What is an S-Corporation?
There are many entity structures you can choose from when starting your business. Sole proprietorship, partnership, limited liability company (LLC), C-Corporation, or S-Corporation. While there are differences among these business forms, the S-Corporations is by far one of the most popular entity choices for small businesses because of its favorable tax status and liability protection.
S-Corporations are tax-efficient because they are not double-taxed like C-Corporations. A C-Corporation pays tax on its net profit and then its shareholders pay tax again when the net profit is paid out to its owners. S-Corporations do not pay federal income tax (although some states do tax S-Corporations). Instead, all income, losses, credits, and deductions of an S-Corporation are passed through to its shareholder. Each shareholder then reports their portion of the pass-through item on their personal tax return.
In addition, an S-Corporation is tax-efficient because it only pays payroll taxes on wages and not distributions. Lastly, a corporation, if properly maintained, can protect personal assets from business liabilities.
The laws covering S-Corporations are covered in Subchapter S Sections 1361 to 1379 of the Internal Revenue Code (IRC).
S-Corp Eligibility
Not all corporations can be an S-Corporation. S-Corporations must apply with the IRS on Form 2553 and meet strict rules to be eligible for S-Corporation status. To qualify for S-corporation status, the corporation must meet the following requirements:
- Be a domestic corporation.
- Meet certain shareholder requirements.
- Have no more than 100 shareholders. There are exceptions for family members.
- Have only one class of stock. Different voting rights are acceptable.
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
S-Corporation Shareholder Requirements
S-Corporations have strict limitations on who can be a shareholder. An ineligible shareholder can terminate an entity’s ability to qualify as an S-Corporation and cause major problems for the remaining shareholders.
S-Corporation shareholders may only be individuals, certain trusts, and estates. The following are prohibited from owning shares in an S-Corporation:
- Partnerships
- C-Corporations
- Individual Retirement Accounts (IRAs).
- and non-resident aliens (with some exceptions) may not be shareholders of an S-corporation.
An S-Corporation can only issue one class of stock. Many large or complex corporations choose C-Corporations (although tax inefficient) so that they can have different types of shareholders. For example, Alphabet, Inc. (parent of Google), has three share classes to allow its founders to retain control of the company:
- Class A: publicly traded and have one vote per share.
- Class B: not publicly traded, available only to insiders, and have 10 votes per share.
- Class C: publicly traded and have no voting rights.
While an S-Corporation can only have one share class, it can have different voting rights. IRC Section 1361(c)(4) specifically states “a corporation shall not be treated as having more than 1 class of stock solely because there are differences in voting rights among the shares of common stock.”
How to become an S-Corporation
You must first form a C-Corporation before you can become an S-Corporation. To form a corporation, you must file articles of incorporation within the state in which you want the corporation to be formed. A newly established corporation is always a C-Corporation first until it makes an election with the IRS by filing Form 2553 to be treated as an S-Corporation per IRC 1362(a).
Tips on how to file Form 2553
- Per the IRS, the election must be made “no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect.”
- Relief is available for late elections.
- All shareholders must consent and sign to elect to be treated as an S-Corporation.
- Per IRC 1378(b), an S-Corporation must use a calendar tax year unless it can make a reasonable business purpose for using a fiscal year.
- Once a valid S-Corporation election has been made by all shareholders, subsequent shareholders do not have to consent nor does the corporation have to make the election each year thereafter.
- Once an S-Corp election is terminated, it cannot make the election again for another 5 years, unless the termination was inadvertent.
- A shareholder cannot revoke an S-Corporation election unless the shareholder owns more than half the shares of the corporation. However, a single shareholder can inadvertently (or intentionally) terminate the S-Corporation election by transferring their shares to an ineligible shareholder.
- A corporation approved for an S-Corporation election will receive IRS Letter CP261 and should keep it in their corporate books.
Maintaining Corporate Books & Records
All corporations, including S-Corporations, must maintain proper books and records to ensure liability protection. Your corporate books and records are private and not filed with any taxing authority, but should be maintained by a corporate secretary in case of an audit and for the purpose of your shareholders. Having proper books and records show shareholders and investors that a corporation is legitimate and professionally managed. Bylaws are not the same as your articles of incorporation which are filed with the Secretary of State.
Corporate Bylaws:
Corporate bylaws are the rules set forth by shareholders for operating a corporation. Bylaws create structure and legitimacy for a corporation when faced with lawsuits, shareholder disputes, or other business activities. The following are examples of common provisions included corporate bylaws:
- Number of members on the board of directors and election terms for directors.
- How shareholders, officers, and directors are appointed and removed.
- Who has the authority to transact on behalf of the corporation.
- Location of the corporate books and records.
- Frequency and location of shareholder meetings.
- Voting rights. Bylaws would state if the corporation has different share classes and/or voting rights.
- Instructions on voting shares and appointing proxies.
- Committees, as created by a corporate resolution.
Stock Certificates:
Used by the company to issue physical shares to shareholders, stock certificates also provide evidence of ownership in a corporation.
Stock Transfer Ledger:
A stock transfer ledger is a document used by the corporation to keep records of all stock transactions. A stock transfer ledger includes the name of the shareholder, certificate number, number of shares issued, date of issuance, amount paid, and other pertinent information about the transaction.
Corporate Resolutions:
A corporate resolution is used by the board of directors to document major decisions. A common corporate resolution for small businesses would be a resolution authorizing an officer or director to open a business bank account on behalf of the corporation.
Meeting Minutes:
Corporation meeting minutes are a formal documented record of meetings and key decisions made by the board of directors. Maintaining corporate minutes. While not all states require corporations to maintain minutes, a well run corporation will keep regular and accurate minutes of their business meetings.
There are companies that offer templated kits which include corporate bylaws, stock certificates, stock transfer ledgers, corporate resolutions, and meeting minutes.
Taxation of S-Corporations
S-Corporation Tax Return
Although S-Corps are not subject to federal tax, they must still file an informational federal tax return on IRS form 1120-S. The 1120-S not only reports the S-Corporation’s income, expenses, and net profit, but it also shows how the net profit is allocated among its shareholders by producing a Schedule K-1 for each shareholder. The K-1 is very important because each shareholder relies on their K-1 to report their share of the S-Corporation’s income, loss, and any separately statement items on their personal tax returns.
Form 8825
Form 8825 is used by partnerships and S-Corporations to report rental real estate activities. The purpose of reporting rental activities on Form 8825 is because rental real estate is a passive activity and is not subject to self-employment tax.
Pass-through entity
S-Corporations are considered pass-through entities and are not subject to federal income tax. Instead, the corporation’s net income flows through to each shareholder from the K-1 is subject to income tax, but not payroll taxes. Some states do impose state income tax on S-Corps.
Reasonable Salary
S-Corps must pay a reasonable salary to shareholder employees who provide services to the corporation. Wages paid to shareholders are subject to both income and payroll taxes. The S-Corp must pay wages before any distributions are made to shareholders to ensure the shareholder employee is paying payroll taxes. The IRS has the authority to reclassify distributions (which are not subject to payroll taxes) as wages (which are subject to payroll taxes) if the IRS believes that shareholders wages are intentionally low to avoid payroll taxes.
Qualified Business Income (QBI) Section 199A Deduction
S-Corporations are eligible for the generous Qualified Business Income (QBI) deduction under section 199A. The 199A deduction allows S-Corporation shareholders to deduct up to 20% of their Qualified Business Income. The QBI deduction is taken on the shareholder’s personal tax return. Not all S-Corporations are eligible for the full deduction. Shareholders of S-Corporations classified as Specified Service Trade or Business (SSTB) must meet certain income limitations to qualify for the generous QBI deduction. Shareholders of non-SSTB S-Corporations whose income exceeds the allowable limits must use a complex formula factoring W-2 wages paid and Unadjusted Basis Immediately After acquisition of the corporation to calculate what percentage of their QBI they can deduct.
C-Corporations are not eligible for the QBI deduction making the S-Corporation a preferred choice over C-Corps.
What is Reasonable Compensation?
The IRS does not define reasonable compensation, but provides some guidance. To determine reasonable compensation, a shareholder employee must identify what services they provide to the corporation and the source of revenue to the corporation. If the source of the company’s revenues is directly due to the services of the shareholder employee, then such income should be classified as wages and subject to payroll taxes. If the source of revenue is from non-shareholder employees (regular non owner employees), capital used by the company, or equipment, then those payments to shareholder employees can be classified distributions not subject to payroll taxes.
Here are some factors the IRS uses in determining reasonable compensation:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
If you’re still unsure how to determine a reasonable salary to pay yourself, one option would be to look on a job board such as Indeed or Zip Recruiter to determine how much it would cost to pay someone to replace you or look on the Bureau of Labor Statistics for very detailed salary information on all types of jobs and their salaries across the country.
Whichever method you choose to calculate reasonable compensation for your corporation, you should document it in your corporate minutes.
Payroll Taxes
Wages, such as reasonable compensation, are subject to payroll taxes, also known as Federal Insurance Contributions Act. Both the employer and the employee pay FICA taxes which are deducted from employee paychecks. As a business owner, If you are a shareholder-employee, then you pay both the employer and employee portion of FICA taxes.
Combined FICA taxes are 15.3% (12.4% + 2.9%) and are broken up into two categories:
Social Security taxes are 6.2% of total compensation. The employee and the employer each pay 6.2% (12.4% total) to Social Security taxes. The government limits Social Security taxes to the wage base which increases every year.
Medicare taxes consist of 1.45% of total compensation and are not limited by an annual wage base. The employee and employer each pay 1.45% (2.9% total) to Medicare taxes.
Total payroll taxes are reported on the employee W-2 form each year along with total compensation.
Employers must also pay Federal Unemployment Tax (FUTA) of 6% on the first $7,000 of wages and file tax form 940 annually. Employers who are also subject to state unemployment taxes are entitled to a federal credit that varies for states who are deemed credit reduction states.
S-Corporation Taxation Example
An S-Corporation passes its net income through to shareholders based on their percentage of ownership. Assume that Steve is a 10 percent shareholder and Mark is a 90 percent shareholder of Newport, Inc. (an S-Corporation) that earns $100,000 in net income. Steve and Mark also provide services to the S-Corporation and each earn $30,000 in W-2 wages. Newport, Inc. will file a federal tax return form 1120-S, but will not pay federal tax. The 1120-S return will generate a separate K-1 for Steve and Mark to prepare their personal tax returns.
On his personal tax return, Mark will report $90,000 of income from his K-1 (90% of Newport, Inc.’s net income) plus the $30,000 of W-2 wages he earned from Newport, Inc. for a total of $120,000 of income. However, Mark will only pay payroll taxes on his $30,000 of wages, not his $90,000 of K-1 distributions. As a result, Mark and Newport, Inc. each save $6,885 (7.65%) in payroll taxes ($90,000 x 7.65%).
S-Corp Separately Stated Items
Separately stated items of S-Corporations include income, losses, deductions, or other items that are taxed differently to shareholders and therefore must be allocated among shareholders through their K-1.
With some exceptions, mostly due to C-Corp conversions to S-Corps, S-Corps income is passed through to the shareholders in the same manner. For example, if the S-Corp earns interest, dividends, rental, or capital gains income, that income flows through to the shareholder in the same manner.
Common examples of separately stated items include:
- Charitable contributions. Donations are not deductible for the S-Corp, but are separately stated for each shareholder to deduct on their own personal taxes.
- Section 179 depreciation.
- Qualified and ordinary dividends received by the S-Corp.
- Net income or loss from rental activities.
- Tax-exempt income.
- Capital gains or losses.
- Gains and losses from Section 1231 property used in business.
- Foreign taxes paid or accrued by the S-Corp per IRC Section 901.
- Portfolio income or loss per IRC Section 469.
- Itemized deductions.
Separately stated items are covered in Internal Revenue Code (IRC) 1366-1.
Tax Filing Deadlines for S-Corporations
An S-Corporation must file a federal income tax return (form 1120-S) by the 15th day of the third month after the end of its tax year, which is March 15th for calendar year S-Corporations. Per IRC 1378(b), an S-Corporation must use a calendar tax year unless it can make a reasonable business purpose for using a fiscal year.
An S-Corporation can use IRS form 7004 to file an automatic 6 month extension to file their tax returns pushing the deadline to September 15th.
The S-Corporation filing due date is before the April 15th individual filing due date (October 15th, if extended) so that shareholders have time to obtain their K-1s from their investments in S-Corporations to file their personal tax returns.
S-Corporation Common Mistakes
- Forgetting to file form 2553. Failure to file form 2553 means you have a C-Corporation and not an S-Corporation and if you attempt to efile an S-Corp return, it will be rejected.
- Commingling assets. Business and personal assets must be kept separate. Otherwise a corporation’s limited liability status can be challenged in court thereby piercing the corporate veil.
- No reasonable compensation. Not paying a reasonable salary to a shareholder-employee is exposing the corporation to an audit.
- Not maintaining books and records. Corporations should keep accurate financial records to track performance. Common financial statements include income statement and balance sheet.
- Not utilizing the “Augusta Rule” IRC 280A. The Augusta rule (formally known as IRC section 280A) allows homeowners to rent out their home to their S-corporation for up to 14 days tax-free.
- Not having bylaws: Corporate bylaws are the rules set forth by its shareholders for operating a corporation. Bylaws create structure and legitimacy for a corporation when faced with lawsuits, shareholder disputes, or other business activities.
- Failure to keep meeting minutes or hold board meetings. Major corporate decisions must be documented in the corporate minutes. Some examples of decisions to document include: deciding to become an S-Corporation; authorizing an officer/director to open a corporate bank account; documenting shareholder loans; etc.
- Not following an accountable plan. Failure to follow an established accountable plan can lead to disallowed deductions.
S-Corporation Shareholder Basis?
Basis is how much economic interest a shareholder has invested in a corporation. Because an S-Corp is a pass-through entity, basis changes throughout the year and therefore must be tracked annually on Form 7203.
Why is shareholder basis important?
Basis is very important in an S-Corporation because it determines how much a shareholder can withdraw from the corporation tax-free. Basis also becomes important when the corporation is reporting losses or if the corporation is being sold. For example, if a shareholder receives a K-1 with a loss, they may not be able to deduct the loss if they have no basis.
As of 2021, S-Corporation shareholders are required to keep track of and report their stock and debt basis in the corporation on form 7203. Basis can never become negative because that means more money has been taken out of the corporation than was invested.
Since a shareholder pays tax on their share of net income of an S-Corp, even if the net income is not distributed, distributions from the S-Corp are not taxable, unless they exceed the shareholder’s basis in the S-Corporation. Distributions in excess of basis are taxable to the shareholder as capital gains.
Stock versus debt basis
S-Corporation stock basis is very similar to debt basis with one major difference. Debt basis can only be created if the shareholder lends money directly to the corporation.
Moreover, debt basis is also tracked on Form 7203 and is separated into two categories: debt with a formal note and debt with an open account.
- Formal notes must have written documentation and be separately tracked for each loan.
- Open account is for shareholder loans to the corporation that are not evidenced with a formal note and are under $25,000.
Furthermore, debt basis is not created if the shareholder guarantees or co-signs a loan by the corporation.
How does the basis increase in an S-Corporation?
Examples of transactions that increase basis include:
- Capital (cash or property) contributions
- Purchase of additional stock
- Net profits from the corporation
- Tax-exempt income
- Shareholder loans made to the corporation create debt basis
How does the basis decrease in an S-Corporation?
Examples of transactions that decrease basis include:
- Distributions (cash or property)
- Net losses from the corporation
- Non-deductible expenses
- Repayment of shareholder debt
What is a Q-Sub (Qualified Subchapter S-Subsidiary)
A Qualified Subchapter S-Subsidiary, also known as a Q-Sub or QSSS, is a wholly (100%) owned subsidiary of an S-Corporation. While S-Corporations have strict rules on who can be an eligible shareholder, an S-Corporation is permitted to own stock in another S-Corporation.
A Q-Sub is used when a parent S-Corp wants to have several businesses under one umbrella. The structure creates a parent / child relationship and if there are multiple Q-Subs under one parent, it creates a brother/sister relationship.
There are legitimate business reasons for S-Subs. A business may want to consolidate operations or certain activities at the parent company. Sometimes a business wants to separate assets or liabilities into separate entities for legal protection.
A huge benefit of Q-Subs is that they are not deemed as separate companies. All the assets and liabilities of the Q-Sub are considered that of the parent. Since a Q-Sub is not considered a separate corporation under federal rules it does not have to file a federal income tax return. However, some states do require Q-Subs to file tax returns and impose a franchise tax on the Q-Sub.
What is a Qualified Subchapter S Subsidiary Election?
A Qualified Subchapter S Subsidiary Election is made by the parent S-Corporation using Form 8669 for each subsidiary they want treated as a Q-Sub. The parent S-Corp must own 100% of the subsidiary to qualify as a Q-Sub. The subsidiary S-Corp status may get terminated if the parent company fails to own 100% of the subsidiary or if the parent company itself no longer qualifies as an S-Corp. A terminated S-Corp or Q-Sub must wait 5 years before they can make the election again.