When you’re thinking about starting a business, one of the options you have is an S Corporation.
Because there are so many options, including S Corps, things can get confusing easily. It’s hard to decide which structure is best for your business and why.
That’s where I come in…
As a business lawyer, I’ve helped hundreds of individuals start their business and make informed decisions. I’m here to help you, too.
I hope you’ll find this article informative and helpful.
If you have any questions or are ready to get started with your own S Corp today, email at [email protected]
Let’s get started…
What is S Corporation?
An S Corporation is a special type of corporation created through the IRS.
By electing to be treated as an S Corporation, the corporation can avoid double taxation.
What makes the S Corporation different from a traditional C Corporation is that profits and losses can pass through to your personal tax return. What this means is that the business itself is not taxed; only the shareholders are taxed.
It is a way to incorporate your business while avoiding double taxation at the same time. It’s more or less the equivalent of a loophole when it comes to business structures.
You get to reap the benefits of being incorporated without having to deal with the downsides (such as double taxation). How does that work exactly?
Well, the profits and losses of your business will pass by your personal tax return. This just means your actual business isn’t going to get taxed – just the shareholders of said business. So, as long as you take care of your personal taxes, you have nothing to worry about.
Why Be an S Corporation?
It’s a good idea to be an S Corporation if your business qualifies because it offers the protections of an LLC with the tax advantages of a corporation. It’s the best of both worlds.
Let’s look into the s corporation advantages and disadvantages more in-depth in the following sections…
S Corporation Advantages
The advantages of an S Corporation include liability protection, avoiding self employment taxes, credibility, and ownership transfer.
Liability protection: An s corp protects the owners from the debts and liabilities of the business in most cases.
Self-employment taxes: An s corporation is required to pay owners a reasonable salary on which they will pay taxes on. This means you get to avoid self-employment taxes altogether because technically, you aren’t self-employed. You’re employed by the S Corp.
Credibility: Forming an S corporation gives your business more credibility than you would have otherwise.
Ownership transfer: Transferring ownership of an S corp is easy and doesn’t require any complicated documents, accounting rules, or tax penalties.
If you would like to know more about the difference between an S Corporation and C-Corporation, read my guide linked.
S Corporation Disadvantages
The S corporation disadvantages include expensive filing fees, limitations on stocks, and more IRS scrutiny.
Expensive filing fees: Forming an S Corporation is more expensive than forming an LLC.
Stock limitations: You can only have one class of stock and only 100 shareholders as an S corporation.
IRS scrutiny: As an S corporation, shareholders have to take a reasonable salary. This causes the IRS to look closely at the S corp and the owners to make sure the payments are classified correctly and considered a reasonable amount.
S Corporation vs LLC
The main reason for making the S corp election is so that the part of the economic gain of the entity can be treated as the profit of the enterprise rather than wages. Unlike wages, S corp profits are not subject to self-employment taxes.
One the one hand, you get the benefit of having only your wages subject to self employment taxes if the LLC is taxed as an S corporation.
On the other hand, your LLC must also comply with all of the ownership rules applicable to S corporations. Those rules include the requirement of a single class of ownership, no non-resident alien members, and no corporations or partnerships as members.
Also, as a separate entity, the S corp must comply with all the withholding and reporting requirements of an employer, a task that wasn’t necessary if the LLC had no employees other than its members.
Checklist for Starting an S Corporation
There are several steps that make up the checklist for starting an S corporation:
- Name your business
- Check that the name is available
- Choose the state you want to incorporate your Corporation in
- Register the name
- Determine who the directors of your corporation should be
- Have a business lawyer file Form 2553 for S-corporation election
Let’s look at these steps more in-depth…
Step 1: Name Your Business
The first step in starting your S-Corporation giving your business an official name.
Have fun with it, but remember you may live in a state where you are required to include an identifying word or abbreviation at the end of your business name to let people know you are a corporation.
However, you shouldn’t look at this as a bad thing. Having “Inc.” at the end of your business name is actually going to make your business more inventing to customers, vendors, and even shareholders.
Step 2: Check that the Name is Available
Next, you need to make sure the name you have chosen is available. Basically, you want to make sure no other business has the same name – or a name too similar to what you have chosen.
You want your name to be unique. Otherwise, people will just get you confused with other businesses.
Step 4: Choose the State You’d Like to Form Your C-Corporation In
Unless you have a compelling reason otherwise, it’s generally best for you to form your Corporation in the state in which you have actual presence.
For example, if your company has an office in California, then you should form your Corporation in California.
If your company does not plan to have a physical presence in the U.S. (meaning that it will operate solely from outside of United States), then you should form your Corporation in Delaware, the most business-friendly state for non-US residents.
You may email me at [email protected] if you have any questions about which state you should form your Corporation in.
Step 4: Register the Name
Have a business lawyer form your C-Corporation by filing an Articles of Incorporation.
You should have your business lawyer draft this essential document.
You can email me at [email protected]m to file your Articles of Incorporation.
Once they are signed and ready to go, they need to be filed with the Secretary of State Office. You will also be required to pay some filing fees.
Step 5: Decide Who the Directors of Your Corporation Will Be
Step five is figuring out who the directors of your corporation are going to be.
Step 6: Have a Business Lawyer File Form 2553 for S-Corporation Election
To have your C-Corporation receive the tax treatment of an S Corp, you must file an election with the IRS using Form 2553.
You must file Form 2553 within the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. If you file it later, your election will be effective for the next tax year.
Have a business lawyer file this form for you if you have trouble forming it yourself. You may email me at [email protected] to get started.
Once you’ve filed these documents and paid the fees – you are legally a S-corporation in that state. Congratulations!
Keep in mind, you still have a few steps to take to get things together…
Step 7: Draft Bylaws for Your Corporation
For step seven, you need to have a business lawyer draft the Bylaws of your corporation. Basically, these are the standards, procedures, and policies of your business.
A lot of times, business owners get their business lawyer to help with this document as well.
If necessary, step eight is to create an agreement for your shareholders.
Finally, you have a few last-minute tasks to complete to really get your corporation on the ground running:
- Open a new bank account just for your corporation
- Get a book to use as the minute book for all business meetings
- ·Plan your first board of director’s meeting
- If you have stockholders, issue certificates
- Take the time to obtain any permits or licenses you need to operate your business
- Get yourself an EIN (Employer Identification Number) from the IRS for tax purposes
Now your business is a legal S-Corporation that is all ready to go!
Remember, I can help you start your S-corporation to make sure it’s done right. Email me at [email protected] to get started
How to Form an S-Corporation
To form an S-Corporation, you should contact your business lawyer to draft and file the required documents.
I know what you are thinking – how do you get this show on the road? Fortunately, forming an S-Corporation is something business lawyers can help you with easily.
Your business lawyer will draft up an Article of Incorporation that must be filed with the Secretary of State.
After you do that, you just need to fill out Form 2553 (Election by a Small Business Corporation) and submit it to the IRS. This is just to cover your bases when it comes to taxes.
What’s the Difference Between an LLC and an S Corporation?
The difference between an LLC and an S corporation mostly relate to ownership, taxes, and existence.
When it comes to an LLC vs an S Corp, and S corp is restricted when it comes to ownership while an LLC is not.
These restrictions include:
- Only one class of stock
- Only as many as 100 shareholders/owners
- Only US citizens or residents can be owners
Furthermore, S corporations have to deal with internal formalities such as adopting bylaws, holding meetings, recording meeting minutes, and issuing stock. An LLC isn’t required (but is recommended) to follow such formalities.
The next different comes with management. An LLC can have owners manage the business or managers manage the business. While an S Corp has to have directors and officers, not owners, manage the business.
The main difference in taxes with an S Corp vs LLC is that S corporations avoid self-employment taxes altogether. This is because S corps are required to pay owners a reasonable salary.
Whereas in an LLC, you have to pay self-employment taxes no matter what.
Finally, transfer of ownership differs between an S Corp and an LLC. Stock in an S corporation is freely transferrable without consequences and complicated paperwork. With an LLC, you can’t easily transfer ownership like that.
How is an S Corporation Taxed?
S Corporations are taxes as pass-through entities. This means there is no federal income tax as the corporate level and any profits are allocated to the owners and taxed at the personal level.
You do have to file Form 1120S for your annual tax return, but the business isn’t required to pay business taxes.
The money that an S Corporation earns leaves the business in the form of owner salaries and dividends.
S Corp Self Employment Tax
There is no S Corp self-employment tax because owners are required to take a salary and the remaining income is distributed as dividends and taxed as unearned income.
This is the main reason an S corp is so appealing because you can avoid paying the self-employment taxes you pay as a sole proprietorship, partnership, or LLC.
Which is Better LLC or S Corporation?
If you can form an S corporation, is it better than an LLC in most cases.
This is because an S corporation offers all the benefits of an LLC as well as tax savings because you don’t pay self-employment taxes.
If you’re unsure which move is the best for your business, email me at [email protected] and I’ll help you decide.
Why Convert to an S Corporation?
There are many reasons that a business may choose to convert to an S Corporation. The main two are limited liability and tax savings.
The first benefit is asset protection. Even though you are embarking on a journey to become a business owner, you are still your own person. You have your own things such as a car and a house.
Converting to an S Corporation is going to protect your personal things from getting looped into the business. It’s the key to drawing a fine line between what’s yours and what belongs to the company.
The second benefit – and perhaps the most important one – is tax savings. If you aren’t an S Corporation, you will have to deal with double taxation. Basically, this means you are going to get taxed as an individual and as a business owner.
If you are an S Corporation, you only have to worry about your personal taxes. It’s the shareholders that get taxed the second time. After all, who wants to pay taxes twice for everything?
If you’re thinking of converting to an S corporation, contact me at [email protected] and I can help.
When to Set Up an S Corporation?
If you are thinking of starting a business and want to form an S-Corporation, you should set one up from the very beginning because it’s much easier than changing later.
If you already have a business and want to convert to an S-Corporation, exploring your reasons would be a good first step.
Whether or not you should be setting yourself up to be an S Corporation really comes down to what you are hoping to gain from the business structure.
If the only thing you need is asset protection, this isn’t the right business structure for you. In fact, an LLC can offer you asset protection. So, that’s the cheaper route to take if that’s all you are after.
An S Corporation becomes the right choice when you are looking to save money on taxes. The benefit of setting yourself up as an S Corporation is you get to pay yourself a reasonable salary and avoid self-employment taxes.
Whether or not you are really going to benefit financially from opting to go with an S Corporation really boils down to your net income. If your net income exceeds three to four thousand, you may want to consider an S Corporation. If your net income, however, doesn’t come close to that amount – an S Corporation may not be worth the hassle.
Income Generated by S Corporations
Income generated by S corporations is passed through the business to the owners in the form of salaries and dividends.
The S Corporation doesn’t pay taxes at the corporate level and the business owner gets to avoid self-employment taxes. It’s a great arrangement for most businesses.
It should be noted that the IRS does watch an S Corporation closely to make sure that the salaries are reasonable and fair. Otherwise, you could allocated most of the income to dividends that you wouldn’t have to pay taxes on.
Can an S Corp Own an S Corp?
An S Corp can’t own an S Corp.
Under the US tax code, owners of an S corp must be US citizens, legal residents, or estates. Some types of trusts may own an S Corp as well.
No corporation of any kind can own an S Corporation. The only exception is through a qualified subchapter S subsidiary, and only applies in some cases.
This technical term, abbreviated QSSS, just means that for an S Corporation to own another S corporation, it must own all the shares.
In other words, S Corp A who desires to own some of S Corp B must own 100% of it or 0% of it.
S Corporation Requirements
The S Corporation requirements are:
- Only one class of stock
- Only 100 shareholders
- Owners must be US citizens and individuals
- Must not be ineligible (certain insurance companies, financial institutions, etc. aren’t allowed to be an S Corp)
The best thing to do is to email at [email protected] about the S corporation requirements to see if you can form one for your business.
Can a Foreigner, Non-Citizen, Resident Alien Own an S Corporation?
Yes, a foreigner, non-citizen, or resident alien can be the owner of an S Corporation under the U.S. tax code.
However, it is next to impossible for a nonresident alien to own an S Corporation.
Surprisingly enough, a pretty large portion of business owners in the United States are not actually citizens.
The key question that needs to be asked is whether they are a nonresident alien or a resident alien as this is really where the line is drawn regarding whether or not they can own an S Corp.
The reason being is nothing more than the fact that a nonresident alien is neither a citizen or a resident of the United States, so it doesn’t make sense for their business to be an S Corp of the U.S. when they have no ties to the country.
If you’re not sure if you can own an s corporation, contact me at [email protected] about your situation and I’ll tell you what the law says.
Can a Non-Resident Alien Own an S-Corporation?
Regarding to the issue whether a foreigner, non-citizen, resident alien can be an S-Corporation shareholder, under the U.S. tax code, a foreigner, non-citizen resident alien may be an S corporation shareholder.
Said another way, an S corporation can be owned by a foreigner, non-citizen, resident alien. However, an S corporation generally cannot be owned by a non-resident alien.
Under United States tax law, an S corporation generally cannot have a “nonresident alien as a shareholder.” IRC § 1361(b)(1)(C). A nonresident alien is neither a citizen of the United States nor a resident alien. Id. § 7701(b)(1)(B). You can read more here.
A person qualifies as a “resident alien” if the person is “a lawful permanent resident of the United States,” fulfills the “substantial presence test,” or fulfills the “first-year election” requirements. Id. § 7701(b)(1)(A).
In order to be eligible to be a shareholder of an S-Corp you need to at least be a “Resident Alien”. There are a two tests to determine if you can qualify as a Resident Alien if you aren’t already a U.S. Citizen.
First, is the “Green Card Test.” This where the alien actually has to be a lawful permanent resident with a green card.I f you have one of these documents it doesn’t matter how long you’ve been present in the country, you can qualify as an S-Corporation shareholder. However, if your Visa is a non-immigrant visa, then that would not be lawful permanent residence, so you wouldn’t qualify under this test.
The second test is the “Substantial Presence Test.” This test is satisfied if the alien individual is physically present in the US for the requisite amount of time, either for the calendar year in question or for the three-year period that ends with the year in question. Regs. §301.7701(b)-1(c)(1).
What If My Partner is a Foreigner?
This shouldn’t effect you in an negative way. However, if your foreign partner is best to have your ‘partnership’ taxed as a C-Corporation, it could have a significant effect on your tax return.
But, in most situation, if you are a U.S. Citizen creating ordinary income, you will most definitely want to consider being an S-Corporation.
If it is a good fit for you , then you can have an S-Corporation and make it a ‘partner’ in the project with your foreigner. However, the best entity for you an your partner can depend in large part on the tax treaty between the U.S. and your partner’s country of origin.
For example, you might need to operate as an LLC, LP, or LLP and then simply have your S-Corporation be the partner or member in that entity.
Sam Mollaei Esq., Business Lawyer
Forming an S Corporation is a great move for most businesses, but there is a lot of information you should be aware of first.
Hopefully this article covered most of that and you can now make an informed decision.
► If you feel like you need help deciding or are ready to move forward with registering your S-Corporation, email me at [email protected] and I can help you.