What is an S Corporation?
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S Corporation Basics
An S corporation is a domestic corporation with a single class of stock and up to 100 shareholders. Shareholders are limited to individuals (U.S. citizens or permanent legal residents) and certain types of trusts, estates, and charitable organizations. Partnerships, corporations, financial institutions, and insurance companies cannot be shareholders in an S corp.
An S corp is similar to other corporate structures in that it is required to have bylaws, issue stock, and elect directors. S corps must hold annual meetings with recorded minutes and file annual reports with the appropriate state government agency.
The S corp is a separate legal entity from its owners and protects them against personal liability for corporate debts and lawsuits. Except in very limited circumstances, the assets of the shareholders cannot be taken to pay corporate debts and liabilities.
How is an S Corporation Taxed?
S corporations are pass-through entities which means no federal income tax is assessed at the corporate level. Business profits are passed through to the shareholders and taxed at the individual level.
An S corp files a 1120S tax return and reports shareholder distributions and deductions on schedules K and K-1.
Unlike other pass-through entities such as an LLC or a partnership, the shareholders of an S corporation don’t pay self-employment taxes on income generated by the business. On the other hand, all shareholders who are employed by the S corp must be paid a “reasonable” salary from which payroll taxes, worker’s comp, and unemployment taxes are deducted. The S corp pays 50% of the payroll tax.
There may be state income taxes, franchise taxes, or gross receipts taxes levied on S corps depending on the state.
S corps cannot retain tax-free earnings; all earnings must be allocated to shareholders each year. Shareholders must pay taxes on the earnings whether or not they receive them. Only C corps can retain and pay taxes on earnings instead of distributing them to shareholders at the end of the year.
S Corp vs. LLC: Understanding the Differences
Both LLCs and S corps are popular business structures for small business owners because they offer personal liability protection and pass-through tax treatment. However, there are certain key differences investors should keep in mind before deciding how to organize their business.
|Formation||Restricted to 100 or fewer shareholders who must be US citizens or legal residents; other corporations, LLCs, and partnerships cannot be shareholders.||An unlimited number of owners/members; can be non-citizens or other corporate entities; can easily form subsidiaries.|
|Management Structure||Board of Directors and Officers (CEO, CFO, etc.)||Owners/members of managers may manage the business.|
|Business Operations||Format structure regulated by state law; must adopt bylaws, issue stock, hold annual meetings, record meetings, and submit annual reports.||Flexible and unstructured; governed by the LLC Operating Agreement.|
Pros and Cons of an S Corp for Real Estate
The choice of business entity doesn’t just affect tax liability; it also has significant implications for overall business operations. The S corp has distinct advantages and disadvantages for real estate investors.
Pros of an S Corporation for Real Estate
- As with LLCs, S corps help shield owners from personal liability from the business’s debt and any potential lawsuits.
- S corps allow pass-through tax treatment which avoids the double taxation that applies to other types of corporate structures.
- The income of an S corporation isn’t subject to self-employment taxes.
- S corps can use the cash method of accounting as opposed to the accrual method required of other corporations.
- Shares in an S corp can be transferred without triggering a taxable event.
Cons of an S Corporation for Real Estate
- S corps only allow one class of stock which makes it more difficult to give some shareholders/owners preferential equity to recognize extra work or contributions to the business.
- Since ownership is essentially limited to individuals, equity financing or investment from other corporations and foreign entities isn’t possible.
- Transferring property into or out of the S corp is treated as a sale, triggering a taxable event.
- Shareholders may not be able to use an S corp loss to offset income from other sources reported on the tax return.
- Property held by an S corp doesn’t get a step-up in basis when a shareholder dies setting up the heirs for income tax on earnings generated by the S corp before they inherited the stock.
How to Form an S Corporation
All corporations are initially formed as a C corporation and must be converted to an S corporation by filing Form 2553 with the IRS. In addition to registering a corporation with the state, owners first draft bylaws, appoint a board, issue stock, and hold a board meeting.
A new corporation can elect S corp status with the IRS up to two months and 15 days after starting its first tax year. Existing corporations can elect S corp status at any time during the current year but the status won’t be effective until the following tax year.
Reviewed by Mark H. Zietlow, Innovative Law Group