The S corporation is a popular business type, but it's often misunderstood. Some say that it's overused as a protection against liability. The S corporation does have both benefits and drawbacks, but it's useful for small businesses that want to protect their owners from liability and enjoy the benefits of pass-through taxes.
A Subchapter S corporation is a corporation whose profits and losses are taxed to its owners on their individual income tax returns instead of to the corporation. Subchapter S status must be elected by the corporation after it's chartered. This allows a corporation to combine the limited liability benefits of a corporation with the tax benefits of taxation at the personal tax rate.
Only certain types of corporations are eligible to elect S corporation status. Requirements include a limited number of shareholders and restrict shareholders to only U.S. citizens. They allow only certain types of entities.
The benefits of becoming an S corporation include lower taxes—both income tax and self-employment tax. The pass-through nature of an S corp allows its owners to reduce their total tax bill or pay at a lower rate than the corporation itself would pay.
The disadvantage of S corp status is the same as that for other corporations—the complexity of requirements and paperwork needed to maintain this status. Forming an LLC doesn't require this same level of detail. For example, a corporation must, by law, have annual meetings but there's no such requirement for an LLC.
The S corp is a type of corporation, but it's taxed differently from a corporation. A corporation pays income tax as a separate entity while an S corp pays income tax through the tax returns of its owners according to their percentage share of ownership.
S corporations and limited liability companies both have limited liability and both have pass-through taxes that are passed to the owners/members. But there are differences in payment to owners/members, as well as in taxes and other key areas.
A business becomes an S corporation in two steps:
- First, the business becomes a corporation by filing Articles of Incorporation with the state.
- Then the corporation elects S corporation status with the Internal Revenue Service.
The election should be made within a specific period of time after incorporation, but it can also be made in any year for the following year.
An S corporation files a tax return for the corporation on Form 1120-S after the corporation's income and expenses, dividends, and other items are distributed to shareholders through Schedule K-1.
You'll need a profit and loss statement for the year and balance sheets for the beginning and end of the year to file an S corp income tax return. You'll also need details on corporate officer compensation, cost of goods sold, and asset records for depreciation calculations.
An S Corp Is a Hybrid
The best way to look at an S corporation is as a hybrid. It's a corporation for legal and liability purposes, and it's a partnership for tax purposes. The S corporation provides liability protection for its owners because it is, in fact, a corporation, and it's, therefore, a separate entity from the owners. But the profits of the S corporation are distributed to and taxed to the owners in the same way as the partners in a partnership.