S Corporation Myths

S Corporation Myths

I want to take the opportunity to address a couple common misunderstandings between legal entities and tax designations. One common question that we get is if I should form an S corporation. The answer to that question, actually, is that you can’t. Let’s step back and look at this holistically.

When you form a corporation or legal entity for doing business, you have a few options. You can be a sole proprietor, corporation, Limited Liability Partnership (LLP) or Limited Liability Company. There are more options out there, but those are the major options. The creation of any of these options is a function of state law.  You undergo the registration process with the state you are doing business in (you can also register out of state – some popular states are Delaware, Nevada, and Wyoming). While you can register your corporation in another state, there will be extra work to comply in the state in which you are operating.

Once you form an LLC, LLP, or a corporation, there are a few options when it comes to taxes. One of those options is to be taxed as an S corporation. The “S” stands for Subchapter S of the Internal Revenue Code. There are advantages from a tax perspective to be taxed as an S corporation, as opposed to a regular corporation, LLC, or LLP.

There are two main kinds of taxation schemes with the IRS. First, there is a flow-through taxation, which means that the taxes to be paid by the business are reported and paid by the owners personal income tax return. All of the taxable activity is paid by the owners of the company through schedule C on their personal tax return. If you choose to be taxed as an S corporation, you actually file a tax return for the company, and then the profits and losses go to the original owners. A corporation doesn’t have flow-through taxation; rather they are taxed as a separate entity, and any dividends that are paid to the owners are taxed as dividends to the owners. Both LLCs and corporations may choose to be taxed as an S corporation if they qualify.

It is often advantageous for tax purposes to file as an S corporation, but it is heavily dependent upon the individual tax situation of the owners. If you have multiple owners, you should be consulting with an accountant to take into consideration all owners’ tax situations in order to make an informed decision.

To qualify to be an S corporation, there are several factors that the IRS requires.

  • First, you have to be a domestic corporation. This means that you are a legal entity registered and based in the United States.
  • Second, you can only have allowable shareholders or members (allowable meaning individuals, trusts or estates). You cannot be a partnership, corporation or non-resident alien shareholder. A non-resident alien shareholder means that you must have permanent resident or citizen of the United States. A U.S. citizen living abroad is still eligible.
  • Third, you can have no more than one hundred shareholders, and if you are a corporation you can only issue one class of stock. If you’re an LLC or LLP, all of those things apply except for the fact that there is only one class of ownership level.
  • Fourth, you can’t be in certain kinds of businesses, such as financial institutions or insurance agents.

If you meet all these criteria, these individuals who are U.S. citizens/residents, have fewer than one hundred stockholders, and you’re based in the U.S., you can choose to be taxed as an S corporation. You may make that election by filing a form with the IRS and have it signed by all shareholders. You must make that decision within 75 days of forming in the business, or within 75 days of the close of your fiscal year (for most folks that would be by March 15).

Here’s the caveat. Once you make the decision, you’re stuck with the decision for at least three years. You can’t change your election to take advantage for changing tax laws. You make that decision and you’re stuck with it (for three years).

Returning to the original point of this post, an S corporation is not a separate type of legal entity. The legal entity is either a sole proprietor, Limited Liability Partnership, Limited Liability Company, or Corporation that is formed with your state. You then make the decision of how you would like to be taxed with the IRS.

If you have any questions about taxation and S corporations, we suggest you talk to an accountant because they need to take a look at your personal tax picture. If you have questions about the legal entity side of things, give us a call.