A Corporation is a legal entity established within a legal framework that can open a bank account, buy property, enter into contracts, and run a business. The first step to starting an S corporation is taking the steps needed to form an S corporation. Then, determining the company’s taxation procedure determines whether the company will be an S corporation. An S Corp is a corporation that has received the Subchapter S designation from the IRS,”
What are S Corporations?
A corporation is an organization authorized by the state to act as a single entity and recognized as such by law for specific purposes. An S corporation, also known as an “S subchapter.” It refers to a type of corporation that meets specific IRC (Internal Revenue Code) requirements.
S corp status gives a business the regular benefits of BASIC incorporation. At the same time, S corporations enjoying the tax-exempt privileges of a partnership. S corps are the type of corporations that elect to pass corporate revenue, deductions, losses, and credits to their shareholders for federal tax rules.
Specifically, S corporations must be individuals, specific trusts and estates, or certain tax-exempt organizations (501(c)(3)). Partnerships, corporations, and nonresident aliens cannot qualify as eligible shareholders.
Definition of S Corporation
Considering corporate taxes, the Tax Reform Act of 1986 made it very attractive to establish an S-Company. S-Corporations are not actually companies with a completely separate structure; The fact of the matter is that public company that has already been established pass through to a special taxation structure as a result of an application made to the IRS (U.S. Department of Revenue). Many entrepreneurs are very inclined to start an S-Company; because this structure structurally combines many advantages of sole proprietorships, partnerships, and public companies.
S corp status’s tax advantages and liability protection make it an attractive option for small business owners.
Benefits of S Corporation
In general terms, S-Corporations carry the advantages and disadvantages of public companies or non-public companies; it only adds its own particular tax conditions. When a standard company (general, non-public, or professional) makes a profit, it pays tax on that profit as federal corporate income tax.
Similarly, suppose such a company announces that it will distribute dividends (sharing the profits of the company to the shareholders in proportion to their share). In that case, the shareholders report these dividends as personal income and pay double-tax on their own income. S-Corporations differ from this in that all incomes or losses are reported at once, under personal tax returns, thus avoiding double taxation (through the company or the shareholders). In contrast, just like in a standard corporation, shareholders of S-Corporations are exempt from corporate debt within their personal liability.
Many people think that running a C company is too complex and expensive. Looking at the examples in the market, they think that C companies are only suitable for those who want to be listed on the stock market. In fact, the choice of C and S companies depends on many criteria. Both types of companies have advantages and disadvantages states, and this also varies.
The biggest difference between C and S corporations is the way the Internal Revenue Service taxes them. An S corporation is distributed dividends to each shareholder at the end of each fiscal year in proportion to their equity stake. Unlike C-corps, shareholders do not suffer from double taxation. These earnings are included in individual income tax returns. So S-Corps offer the same legal protection as the other entities. By the way, its advantage is: earnings in excess of the S-Corps shareholder’s salary are not subject to tax (self-employment)
Summary of Benefits
- tax benefits
- Liability protection
- Ease of conversion
- Salary and dividend payments
S Corps Restrictions
- S corps number of shareholders is limited with max 100
- S corps must be a domestic business entity.
- S corporation shareholders must be U.S. citizens or residents of the U.S.
- S corps can only offer only common stock.
Brief History of S Corporations
In the USA, a company can apply for S status at the establishment stage, according to taxation procedures, but the history of S company type is not very old.
Before the S corporation came into effect, there were two different options for startups for entrepreneurs. A standard corporation (C-corp) or a partnership or sole proprietorship. The C-corp company type had the disadvantage of double taxation. In sole proprietorships, the owner’s personal assets were at risk due to the company’s debts. In short, there was a need for a type of company that would not be subject to double taxation and that the assets of the company’s shareholders would be exempt from company debts.
Both C-corps or sole proprietorships were not ideal for family businesses. In 1946, the U.S. Treasury Department proposed a third corporate option: combining a single federal tax tier with comprehensive liability protection.
However, it was said that this type of company type would cause large companies to pay fewer taxes and cause multinational companies to consolidate the market. There were concerns such as the further centralization of the economy and the monopolization of power centers.
Considering these concerns, a law was enacted in 1958, which consists of various tax items and regulates the taxation procedures of companies. According to subsection S of this tax code, entrepreneurs choosing S corporation status in exchange for benefiting from a single tax tier accepted the following limitations:
- S corp must be a domestic enterprise
- S corps number of shareholders must be subject to restrictions
- S corps must own only one class of shares
In 1958, the highest income tax rate was 52% for companies and 91% for individuals. This meant that dividends paid by a C corporation to a high-income shareholder were subject to an effective tax of 96%.
The establishment of the S corporation was a positive step towards eliminating a devastating double tax and encouraging small and family business establishments in the USA. This new type of company, which does not contain double taxes and protects the company members’ personal assets, was met with intense interest from small businesses and family companies.
Today, S corporations are the most popular corporate structure in America. According to The IRS records, approx 5 million S corporations in the U.S. Considering that the number of C companies is close to 2 million, we can say that S companies are the cornerstone of America’s small business community.
Although S companies are the most common form of business structure, we can say that the LLC (Limited Liability Corporation) company type, which was introduced in 1995, is becoming more and more common. Unlike S corporations, LLCs can be formed by non-US citizens and non-US entrepreneurs. LLCs are functional to stimulate the U.S. economy and enable foreigners to invest in the U.S.
LLCs do not have the drawbacks of S corporations, such as limitations on the number of shareholders and type of shares. Because of this flexibility, the number of LLCs has grown to over 2.5 million. Statistics show that most current S companies are family businesses that have been in operation for many years. For the last ten years, entrepreneurs have been choosing LLCs more than S corporations.
Basic Conditions to Become an S Corporation
– Fewer than 100 shareholders
– All of the shareholders are American citizens or have a residence permit
– Not having a relationship with another company
– Whether the shareholders are individuals, estates, or trusts
– Being a local company
– Having one type of share class, i.e. common stock, preferred shares, or similar single class ownership indicator
Businesses Prohibited from Operating as an S Corporation
- Credit Unions
- Insurance Companies
- Businesses that generate more than 95% of their gross income from exports
- Companies using a certain type of foreign tax credit known as a property tax credit
How to Form an S Corporation
Each state has its guidelines for filing with the IRS as an S corporation. However, most of the steps to be taken during the establishment phase of the company are standard. It is possible to form an S corporation by following these guidelines
a) Make sure your business name is available in your state.
b) Register a “Doing Business As” name.
c) Prepare your articles of incorporation.
d) Prepare the corporate bylaws.
e) Keep corporate minutes of all board and shareholders meetings.
f) Apply for an Employer Identification Number (EIN) with the IRS.
g) Secure permits and business licenses.
Be an eligible, domestic corporation.
a) Have only one class of stock.
b) Have no more than 100 shareholders.
c) Have only shareholders that comprise individuals.
d) Choose a tax year range that suits your company (for example, The tax year ending on December 31.)
a)File your articles of incorporation.
File as an S-corp with the IRS
Switching From C To S Corporation
If the existing C corporation is already eligible for S corporation status, you need to complete IRS Form 2553. cannot be converted to an S corporation. This is because of the maximum limit of 100 shareholders placed on S corporations. If a C corporation has non-US shareholders and non-US citizens, it is impossible to convert the company into an S corporation.
How To Apply To Become An S Corporation?
To become an S-Corporation, you must first know how to apply for special tax status. The first step to incorporating an S corporation is a set of procedures for incorporating a private or professional corporation. Written documents are then drawn up showing that each shareholder has given consent for the company to become an S corporation. Shareholder approval should also be included in the company’s meeting records.
After these processes, Form 2553 must be completed and submitted to the IRS office in the region where the company is located. Before proceeding with S corporation formation, it is recommended that you consult the IRS office you are applying for and inquire about the timetable and how to complete the form.
Differences Between S Corp and C Corp
1) Number of Shareholders
- S Corporations can have a maximum of 100 shareholders.
- There are no shareholder limits for the C corps.
2) Nationality of shareholders
- S corporation shareholder must be a U.S. citizen or resident.
- There is no restriction, but the U.S. and non-U.S. citizens could be shareholders of an S corp.
3) Locality of Operation
- S Corps can operate outside the U.S., only operate locally and within the domestic states.
- C Corps may operate on a global scale, may have foreign subsidiaries.
4) Share Classes
- S corporations are proper only issue one class of stock
- C Corps can have a different kind of stock, so there is no any limit.
- Internal and external formalities are almost the same for both business types. Both corporation types have extra formalities than LLC and sole partnership.
6) Ownership Transferability
- S corporation shares are easily transferable.
- In Company C, members’ approval is required to transfer shares.
7) Tax Payment
- S corp’s revenue is not taxed at the C corp level. It’s only taxed when paid out as employee fees or dividends to shareholders.
- C corporations should pay taxes as though they and their shareholders are two separate legal entities or “persons” subject to tax.
S Corporation Pros & Cons
- Tax benefits: There is a corporate tax advantage for the company. For shareholders, it is an advantage that there is no double taxation.
- Protections of incorporation: limited liability, easy share transfer
- S corporations have credibility on both bank and finance companies.
- Ability to take on More Investors: Max 100 shareholders
- Simpler Accounting Methods
- High costs of incorporation
- Complex compliance rules
- Potentially growth-inhibiting qualifications to maintain the status
- S corps is a type of company that is not recognized in some states or is subject to many detailed legal formalities.
- Limited Stock Class
- Limited shareholders (max 100)
- IRS Salary Requirement
Limitations on S-Companies
In order to obtain S-Company status, a company must comply with certain rules. Within the scope of the Tax Law enacted in 1996, most of these compliance rules have been changed as of January 1, 1997. The highlights of these changing rules are as follows:
- Prior to the 1997 Tax Act, an S-Company could have a maximum of 35 shareholders; its raised to 75. (This number is currently 100.)
- Previously, possession of S-Corporations was limited to persons, real estate, or certain assets. With the changed law, shares of an S-Company can also be held by a new “selective small business trust”. All beneficiaries of this trust (asset) must be persons or immovables. Only charitable organizations can have a limited stake in these trusts; however, this share must be passed on only by donation or bequest; that is, charities cannot buy shares through shares. Each potential guardian is considered to be included in the total number of shareholders of 75, and the calculation is made accordingly.
- S-Corporations cannot own more than 80% of any public company (“C-Corporation”); because this rate gives them the right to declare combined income with other general companies, in which S-Corporations are not inherently involved.
- Qualified retirement plans or charities under Section 501(c)(3) can become shareholders in S-Corporations after the changes.
- All shareholders of S-Companies must be U.S. citizens or permanent residents of the U.S.
- S-Companies may only sell one type of share.
- No more than 25% of the total company revenues can be deducted from the company’s passive income.
- S-Companies may grant non-salary benefits to their employees and prepare term compensation plans.
- S-Corporations can avoid the problems and claims of excessive compensation faced by standard companies due to shareholder-employees.
- In addition, some businesses may legally prevent a company from becoming an S-Corporation.
Chief among these are:
- As a financial institution, for example, banks
- Insurance companies taxed under Subchapter L
- Local International Sales Companies (DISC)
- Certain companies and groups of companies similar to these
- It should be noted that the requirements set out here do not include all the necessary conditions to become an S-Corporation. In addition, in certain circumstances, an S-Company may also be charged income tax. You can consult your accountant, attorney, or IRS offices for more detailed information.
Dissolution of an S Corporation
Dissolution of an S corporation is made with the approval of the corporation’s shareholders by a written statement to the Secretary of State or the authorized service center in the district in which the corporation was established. The documents to be prepared and the forms to be filled are delivered to the company officials who apply to dissolve the S company. When S Corp is terminated through the Secretary of State, the IRS must be notified. The IRS will provide the Secretary of State with the information needed to complete the termination process.
In order the speed up the S Corp termination process, the following actions are requested:
- Reconciliation of the shareholders and voting to dissolve the company.
- The company terminates its current business and ceases its operations. .
- Informing the creditors of the company about the termination.
- Liquidation of company assets.
- File a termination certificate.
- Finalized corporation taxes.
- Filing Tax Forms and Paying Final Expenses
Examples Of C Corporations
S corporations have limited growth capacity as they are not allowed to go public and be traded on many stock exchanges like C corporations. Therefore, the major companies and globally recognized brands we know today are all C corporations or LLCs. In the USA, however, there are S corporations that are recognized in certain cities.
Many of the following businesses are S corps. Although these types of businesses have turned to LLCs in recent years, S corps is still the reason for preference, especially for small businesses established with the partnership of family members.
- Local pizzerias and Restaurants
- Dry cleaners, Tailors,
- Auto repair shops, Carwashes
- Book stores, Music stores
- Construction companies.