The S-Corp: What Is It Exacty?
Is an S-Corp a Business Entity? Nope!
If you’ve ever asked someone what type of business entity they have (just me?), you’ll probably hear that they have a limited liability company (“LLC,”) a corporation, partnership, or that they’re a sole proprietor.
But sometimes you’ll hear someone say that they have an S Corporation, or S-Corp, for short. And while that’s great information to have, that’s actually the answer to a different question.
When you form a business entity, you do so with the department of state, or equivalent office, of the state you’re incorporating, organizing, or registering your business in. That’s why you’ll hear phrases like Delaware corporation or Wyoming LLC. It’s a corporation formed under the laws of Delaware, or an LLC formed under the laws of Wyoming. Business entities are not formed under the laws of federal government of the United States.
That is what it means when someone says, “a business entity is set up at the state level.” It’s a process controlled by a state government and governed according to the laws of that state. For example, under the laws of Florida, you can form a corporation, LLC, limited liability partnership, limited partnership, not-for-profit corporation, among others, but there isn’t a business entity called an S-Corp.
And, even in states like New York, that have a state income tax and allow for state-level S-Corp elections, you don’t form an S-Corp. You form a business entity with the Department of State and then elect to be treated as an S-Corp. It's a separate filing with the New York Department of Taxation and Finance.
An S-Corp is a Tax Election
And that’s because an S-Corp is a tax designation. It’s telling the Internal Revenue Service, and other taxing authorities, how you’d like to be taxed. Other tax designations include Disregarded Entities, and the C-Corp, which experiences the infamous double taxation of corporations.
Double Taxation and the History of the S-Corporation
The S-Corp came about in 1958, when Congress amended the Internal Revenue Code to allow small businesses to avoid the double taxation that came with doing business as a corporation. When you do business as a corporation you get limited liability protection, which basically protects your personal assets from the debts and liabilities of the business. This made corporations the preferred way of doing business, especially when the other option was being in a sole proprietorship or partnership where you were personally liable for the business (the first statute allowing for LLCs did not come into existence until 1977, which was 19 years later.)
However, one of the biggest complaints about doing business as a corporation was the double taxation that came along with it. If you do business as a sole proprietor or partnership, you will only pay tax once, on your individual tax return, for your percentage of the gains and losses of the business. But, because a corporation is considered a person in the eyes of the law, it must pay taxes on its own earnings. This taxation of the corporation’s earnings is the first layer of tax.
Then when a corporation transfers its profits to its shareholders (i.e. the people who own the corporation) in the form of a distribution, the shareholders must pay personal income tax on that distribution. This taxation of the shareholder for receiving the distribution is the second layer of tax.
As you can imagine, many small businesses found double taxation onerous. So, to allow small businesses to avoid double taxation, Congress enacted Sub-Chapter S, which is where the S-Corp gets its name. By utilizing Sub-Chapter S, shareholders of a corporation can have the first layer of tax disregarded, thereby having the gains and losses “flow through” to them. They still have to file an information return, like a partnership does, but the taxes are accounted for in the shareholder’s individual return.
S-Corp Requirements
But this isn’t for everyone or every corporation. In exchange for only paying one level of tax at the individual level, an S-Corp must adhere to each of the following rules at all times:
Have less than 100 or fewer shareholders,
Only have individual (i.e. human) shareholders (there’s a limited exception for the estates, trusts, and certain exempt organizations,)
All shareholders must be U.S. citizens or resident aliens,
Only one class of stock, voting and nonvoting shares are allowed, but every shareholder must have the same rights and priority upon liquidation of the corporation, and
Do not be one of the following types of corporations:
An insurance company taxable under Subchapter L,
A bank or thrift company that uses the reserve method of accounting for bad debts, or
A current or former domestic international sales corporation.
If these rules are broken, the S-Corp tax status is revoked and the business entity will experience the double taxation of a C-Corp.
S-Corps vs LLCs: Self-Employment Tax Savings
S-Corps tax-status has remained popular to the current day, even with the advent of LLCs, which also offer the combination of pass-through taxation and limited liability protection an S-Corp provides. This is because S-Corp tax-status can save shareholders significantly on self-employment tax by dividing compensation into a reasonable salary which is taxed, and distributions which are not.
Form 2553: How to Make an S-Corp Election
As mentioned earlier, S-Corp status is a tax designation. It’s not a business entity or default tax status of any business entity. To make an S-Corp election, Form 2553, titled Election by a Small Business Corporation must be timely filed with the IRS.
If Form 2553 is not filed the first year the business entity is in existence, it is considered timely filed any time in the year before the tax year you want the S-Corp election to be effective or no later than two months and fifteen days after the beginning of the tax year you want the election to be effective.
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