Starting An S-Corp: Everything You Need To Know

S-corp is a tax designation spelled out in subchapter “S” of the Internal Revenue Code. A corporation may elect “S” status if it meets the requirements of the subchapter. The key characteristic of an S-corp is its “pass-through” tax structure, which the IRS describes as passing “corporate income, losses, deductions and credits through to shareholders for federal tax purposes.”

S-Corps, C-Corps and LLCs

New business owners must face an oft-confusing set of choices around the labels S-corps, C-corps and LLCs. The most important thing to know about S-corps when deciding between establishing your business and electing among various structures and tax statuses is that an S-corp is not a business structure. While corporations and LLCs are both types of legal entities, an S-corp is a tax status (or tax designation) with certain added advantages and restrictions.

To receive the S-corporation tax status, you must initially have created your business as either an LLC or a corporation by filing documents with the state. Once your business has officially been formed and you’ve obtained a federal tax ID number, you can send Form 2553 to the IRS to indicate your desire to do business as an S-corp. We’ve provided detailed steps below.

For more specifics, check out our guide to S-corp requirements.

Determining if an S-corp is the best tax designation for you and your business is the first step in starting an S-corp. You’ll need to carefully evaluate the pros and cons of S-corp status and make sure your business meets the IRS requirements.

Electing S-Corp as an LLC

LLCs are popular with small business owners because they allow for a simpler and more flexible ownership and management structure than a corporation. By default, a one-owner (or “member”) LLC is taxed like a sole proprietorship, and a multi-member LLC is taxed like a partnership. Either way, members are considered self-employed and will pay Medicare and Social Security (or “self-employment”) taxes of 15.3% (up to federal limits) as well as personal income tax on their share of company profits.

This tax arrangement works well for many LLCs, but as the business becomes more profitable it may make sense to consider electing S-corp taxation. With S-corp status, owners can be company employees, as long as they pay themselves a reasonable salary. The salary is subject to traditional payroll taxes and is considered a company expense. Any additional profit is not subject to self-employment taxes, potentially saving the owners money.

For more specifics, check out our guide to LLCs vs. S-corps.

Electing S-Corp as a Corporation

Starting a corporation may be the best choice for your business if you anticipate a large amount of growth, if you plan to have a high number of shareholders that might include international shareholders, if you hope to raise equity financing or if you intend to issue multiple classes of stock.

As a corporation, your business will automatically be classified for tax purposes as a C-corporation. In a C-corp, earnings and realized gains are taxed first under a corporate income tax. Distributions to shareholders are taxed again as personal income. This double taxation is a major disadvantage of C-corp taxation for small businesses.

Electing an S-corp tax status for your corporation is a great solution for business owners who want the ability to issue stock and have shareholders while taking advantage of the so-called pass-through tax structure. S-corporations allow businesses to pass through all corporate income, losses, deductions, credits and taxes onto their shareholders while still retaining a corporate structure. However, because of the limitations on ownership, shareholders and stock classes, S-corp status may not be a good choice if you are trying to attract outside investment for your startup.

The exact steps required when electing S-corporation status will depend on whether you have already formed a corporation or LLC. If you have not yet registered your business, check out our more specific guide on forming an LLC. The guide below outlines the most common steps to electing S-corp status as either an LLC or a C-corp, but you should always do research into the specific requirements of your jurisdiction. You can contact the agency that regulates income taxes in your state for more detailed information on any requirements of S-corp election.

Step 1. Form Your LLC or Corporation

If you do not already have a legal business entity, you will need to choose an available business name for your LLC or corporation and register with your state’s business formation agency (typically the secretary of state). This will likely require a registered agent and may require drafting articles of organization, incorporation or additional bylaws as well as providing a list of officers or members. You can check out our state-specific guides to LLC formation, including our list of the best LLC services for those who don’t want to do it themselves.

Step 2. Get a Federal Tax ID Number

Before you can elect S-corp status, you’ll need a Federal Employer ID Number, also known as a FEIN, EIN or Tax ID. Once your business has been officially formed, you can get a FEIN at no cost on the IRS website.

Step 3. Ensure Your Existing LLC or Corporation Meets the Requirements

To elect S-corp status, your LLC or corporation must:

• Not issue or have issued more than one type of stock
• Not have more than 100 shareholders, which:
  • May be individuals, certain trusts and estates
  • May not be “nonresident aliens,” corporations or partnerships

In addition, your business cannot be an “ineligible corporation,” defined as certain financial institutions, insurance companies and domestic international sales corporations.

Step 4. File S-Corp Election Paperwork

If you meet IRS requirements, you can elect S-corp status by filing Form 2553, Election by a Small Business Corporation.

If you file paperwork and complete the process within two months and 15 days after the beginning of the current tax year, you may be able to claim S-corp status for the current tax year. If your election falls after this, it will be valid for the following year.

Step 5. Maintain the Requirements

You don’t need to renew your S-corp election each year, but you do need to make sure your business continues to meet the requirements for shareholders and stock. If it doesn’t, you’ll need to return to a C-corp status or traditional LLC taxation structure.

Establishing your business as an S-corporation has many benefits, most of which revolve around tax advantages. Some specific advantages of an S-corporation include:

Pro Rata Pass-Through of Taxation, Income and Losses

One of the key features of an S-corporation election for a corporation is pass-through taxation. While C-corps are subject to “double taxation” where distributions to shareholders are taxed twice, S-corps are not subject to corporate income tax, so distributions are only taxed once—when received by shareholders.

The S-corp’s profits (and losses) are passed through to owners on a pro rata distribution basis, meaning these items are allocated based on each individual shareholder’s proportionate ownership of stock shares.

Tax-Deductible Expenses and Self-Employment Tax Savings

An S-corporation’s business expenses are still tax-deductible, meaning businesses can save big on taxes during the year. Additionally, an S-corp can offer self-employment tax savings for LLC owners since the owners can be classified as employees.

Electing S-corp tax status for your LLC or corporation can be fairly simple. The biggest and most important obstacle is the research and consideration of the best tax status election for your business’s needs. In other words, “What makes sense for you?” It’s always a good idea to talk to an experienced business accountant before you make a decision.