Entity Formation Basics: The S Corporation
Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.
This post is about a very common form of entity for smaller companies – the “S corporation.”
A corporation is defined as an independent legal entity that is owned by shareholders. A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders. Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.
While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.). If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President. Understandably, this may get confusing! However, it is important to realize each role carries its own duties and responsibilities under the law. As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.
Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here. If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).
Forming an S Corporation
A corporation is formed under the laws of the particular state in which it is registered. To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office. The individual who actually files these formation documents is usually called the “Incorporator”.
Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors. Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).
After the corporation, the IRS by default will treat it as a C corporation unless or until you file Form 2553 with the IRS. In other words, an S corporation is really just a special type of corporation created through an IRS tax election.
“Pass Through” Taxation
Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types. (For a discussion of C corporations, click here.)
Traditional C corporations are separately taxable entities who pay taxes at the corporate level, and then shareholders who receive dividends pay taxes again at the individual level.
In contrast, S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level. Instead, the profits and losses of the business are “passed-through” to the owners to be reported on their personal tax returns. Any tax due from company profits are thus paid at the individual level by the owners, not the company.
If you are a small business owner contemplating receiving regular payments from your corporation’s net profits, ensuring your Form 2553 is filed right away is crucial.
An S corporation can have only one class of stock. Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights, which is a strategy that might be desired if you are looking to have investor shareholders with less management and dividend rights than the company’s founders. Additionally, the one-class-of-stock restriction also means an S corporation cannot easily allocate losses or income to specific shareholders, as is allowed in a partnership or LLC.
With some limited exceptions, a shareholder in an S corporation cannot be another entity; a shareholder can only be an individual. Also, there cannot be more than 100 shareholders. For this reason, startups who are seeking to fundraise through equity financing or going public might find they quickly hit the 100 shareholder limit.
Finally, foreign ownership of an S corporation is prohibited. Every shareholder in an S corporation has to be a U.S. citizen.
Bookkeeping and accounting issues for an S corporation may be more complex than other entity types.
Money distributed to a S corporation shareholder can be in the form of distributions or a salary (assuming the shareholder is also running the company as an officer). There are more burdens with taking a salary (higher tax rate, employer tax obligations, preparing a W-2 form, etc.), so the savvy S corporation owner may try to take as much of his or her income from the S corporation as distributions. Of course, this ultimately means less tax money for the IRS, and so this is a hot button issue for them! The IRS scrutinizes the payments an S corporation makes to its shareholders to make sure the characterization conforms to reality. If the IRS targets your business, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.
Also, as discussed above, the allocation to shareholders of an S corporation’s income and loss is governed by stock ownership, and there are complex rules for how this is to be done. As such, maintaining an S corporation’s books properly can be cumbersome. Having a good accountant to assist with this aspect of your business is absolutely essential!
If you’re considering starting a business or revisiting a current one, contact us today.