S Corporation Guide

Why is it Beneficial?

S corporations provide shareholders, the company owners, with three primary benefits – liability protection, favorable tax treatment, and easy transfer of ownership. Let’s go into these in more detail.

Liability Protection

S corporations provide the benefit of three different types of liability protection which can help protect a business owner’s assets:

• Limited Liability: Shareholders are not personally responsible for the corporation's debts or legal liabilities beyond their investment in the corporation. This means that in most cases, creditors or legal claimants cannot come after the personal assets of shareholders to satisfy the corporation's obligations.

• Legal Entity Status: A corporation is a separate legal entity from its owners, which means that it can enter contracts, own assets, and sue or be sued in its own name. This helps to shield shareholders from personal liability for the actions of the corporation.

• Shareholder Limited Liability: Shareholders are not responsible for the actions of other shareholders or the management of the corporation. Each shareholder's liability is limited to their investment in the corporation.

This is like the liability protection offered by traditional C corporations and limited liability companies (LLCs). It enables entrepreneurs to run their businesses while shielding their personal finances and assets from many of the risks and liabilities associated with commercial activities. For example, if the corporation is sued or cannot pay a business debt, the creditors cannot seize the personal bank accounts, personal homes, personal cars, or other assets of the individual shareholder to satisfy the obligation. 

Favorable Tax Treatment

S Corporations also have some potentially favorable tax rules. An S corporation allows owners who work for the company to take a portion of the profits as salary while taking the remaining portion as distributions (also called profit). 

The compensation for an owner must be “reasonable compensation” that is similar to employees based on their job duties, experience, and hours worked. There is a methodology to create reasonable compensation but know that it is typically 35-60% of the total compensation for an owner. A portion of the reasonable compensation is subject to payroll taxes including Social Security, Medicare, and unemployment tax (for a total federal tax of 15.3%). The remaining portion of the reasonable compensation is called profit, or owner’s draw, and is subject to income tax. 

In contrast, distributions bypass payroll taxes and go right to being subject to income tax. As a result, the owner saves 15.3% of the money they receive as distributions. 

Easy Transfer of Ownership

Third, S corporations have a more straightforward process for transferring ownership interests. Many child care businesses are sole proprietorships. In a sole proprietorship, the owner is the business – there is no separate entity. Accordingly, when the owner wants to sell the business or leave it in their estate for a loved one, there’s no simple way to do it. However, shares in an S corporation can be easily sold or transferred to other individuals or entities, facilitating changes in ownership without disrupting the business operations.

How to Create an S Corporation

There are two ways to get the benefits of an S Corporation. First, you can incorporate as an S Corporation. Alternatively, you can become a Limited Liability Corporation and elect to be treated as an S Corporation. Both these avenues are detailed below.

To form an S corporation, you must follow these five basic steps:

1. Choose a name for your corporation that is not already in use by another business and complies with your state's rules for business names. The name must include a corporate designation like Inc., Corporation, or the abbreviation Corp. 

2. File articles of incorporation with your Secretary of State or similar agency in your state. The articles of incorporation typically include basic information about the corporation, such as its name, principal office address, registered agent (individual designated to receive legal documents on behalf of the corporation), purpose, duration, and the number of shares of stock it is authorized to issue. Most states provide forms that lay out the required article’s content. You may want to have a lawyer review them for compliance.

3. Hold an organizational meeting to adopt bylaws, elect officers and directors, and take other necessary actions to organize the corporation per state rules. Bylaws provide the operating framework, including rules for holding meetings, voting procedures, electing officers, and managing day-to-day business activities. If you are the sole owner – this meeting can just be you! 

4. Obtain an employer identification number (EIN) from the IRS, which is used to identify your corporation for tax purposes. This is done by filing IRS Form SS-4 which can be obtained online. The EIN is like the corporation's Social Security number for tax filing and reporting purposes. You can apply for an EIN with an existing SS number or an ITIN.

5. File Form 2553 with the IRS to elect S corporation status. This form establishes your business as an S corp for tax purposes. The form must be filed within 75 days of the corporation’s incorporation or at the beginning of the tax year for which the election is to be effective. All shareholders must consent to S corporation status on the form. There is no filing fee.

Limited Liability Companies (LLCs) can also elect to be treated as an S Corporation. An LLC is a creation at the state level, so for federal tax purposes, they can elect (that is, choose) to be treated as an S Corporation. In this case you would set up an LLC per your state laws and file Form 2553 with the IRS. This designates you as an S Corporation for tax purposes. LLCs can make this election when incorporated or typically within 5 years of making a tax classification change (so if you elect to become an S corporation, you will want to wait 5 years before changing to another form such as a partnership or single member LLC). 

How to Manage an S Corporation

Once an S corporation is formed, there are several ongoing responsibilities and obligations for managing it properly:

• Keep business finances completely separate from personal finances. Maintain separate bank accounts and credit cards for personal and business use, and do not commingle funds. Careful record-keeping is essential to preserve liability protection.

• Hold annual shareholder meetings and maintain detailed meeting minutes. If it is just you- this will be pretty easy! 

• Maintain accurate financial records showing assets, liabilities, income, expenses, and equity. 

• Pay required federal, state, and local taxes in a timely manner, including payroll taxes to the S corporation’s employee(s). Estimate payments for distributions may be required quarterly to avoid underpayment penalties. 

• Have written shareholder agreements outlining rights, responsibilities, and ownership transfer procedures. 

• Pay reasonable salaries to shareholders who are employees of the corporation. This is important for IRS purposes, as this is auditable and will be reviewed, to justify paying the remaining profits as S corporation distributions. 

• File annual reports with state governments, if required. 

• Report any changes in ownership structure to the IRS, such as if shareholders are added or removed. Submit an updated IRS Form 2553. Also report address changes, contact information for officers, employees, etc.

Finally, make sure you file your taxes! An S corporation does not pay federal income tax at the corporate level. Instead, the income, deductions, and credits of the S corporation flow through to the shareholders, who report their share of the income on their individual tax returns.

The S corporation must file an informational tax return with the IRS, Form 1120S, which reports the income, deductions, and credits of the corporation. This return is due by March 15th of each year, or the 15th day of the third month following the end of the corporation's tax year.

Each shareholder receives a Schedule K-1 from the S corporation, which reports the shareholder's share of the corporation's income, deductions, and credits. The shareholder must report this information on their individual tax return, Form 1040.

The S corporation may also be subject to state and local taxes, including income tax, sales tax, and employment tax. The requirements for filing state and local taxes vary depending on the state and locality in which the corporation operates.

It's recommended to consult with a tax professional to ensure that you are properly reporting and filing taxes for your S corporation.

Frequently Asked Questions

What should be included in the S Corporation Shareholder Agreement?

You want to have a written document. It should address topics like requirements for holding meetings, electing officers/directors, voting rights, dividends, buying/selling shares, and decision-making authority. Make sure you sign and date it or clearly reflect the board meeting at which it was approved. 

What should be included in S Corporation minutes?

S Corporation minutes should include a record of the discussions and decisions made during shareholder meetings as well as:

1. Date and location of the meeting.

2. Names of the attendees, including shareholders, officers, and directors.

3. Approval of minutes from the previous meeting.

4. Reports from officers and committees, including financial reports.

5. Discussion of any new business or proposals brought before the meeting.

6. Votes on any resolutions or decisions made during the meeting.

7. Election of officers or directors (if applicable).

8. Any other business or matters discussed during the meeting.

What are the requirements to elect S Corporation status?

The requirements include having 100 or fewer shareholders, having only one class of stock, not having nonresident alien shareholders, and being organized in the U.S. (with some exceptions). Shareholders can only be individuals, estates, certain types of trusts, or certain exempt organizations.

What are the advantages of an S Corporation? 

Key advantages include liability protection, avoiding double taxation on profits, allowing company losses and deductions to pass to shareholders, and potentially avoiding some payroll taxes.

What are the disadvantages? 

S Corporations come with more complex recordkeeping and regulations, including holding formal director/shareholder meetings and putting salary and profit distributions in writing. There are also limits on the types of shareholders and number of shareholders.

What should I do if ownership changes?

You will want to file a Form 2553 with the IRS noting the changes. Also, you will want to follow up with your state’s Secretary of State and follow their procedures for a state-level recording.