S-Corporation Guide: How to Form an S-Corporation

An S-corporation, or S-corp, is a business entity designated under Subchapter S of the Internal Revenue Service's internal revenue code. Sometimes referred to as a “small business corporation,” an S-corp combines the protection of a limited liability company (LLC) with the corporate-level status of a regular corporation (legally known as a C-corporation).

The IRS grants certain tax advantages to a business with S-corp status. The corporation does not pay federal income tax; rather, its profits pass through to the business owners, who report them on their personal income tax returns. Thus, a business with S-corporation status avoids paying double taxation on its corporate income. An S-corporation also grants limited liability to its owners. If the company incurs debt or faces a lawsuit, the business owners are not held personally responsible, and their personal assets are not at risk. A lender or a litigant can go after the business itself—not its individual owners.

Publicly traded corporations listed on the New York Stock Exchange and the NASDAQ are C-corporations, or C-corps. C-corporations can easily grow in size and take on new investments, but they do not enjoy the same tax benefits as S-corporations or LLCs. Under IRS tax law, a C-corp pays corporate tax on its business income. The dividends paid to its owners are then subject to their own federal tax.

Much like S-corporations, LLCs, and limited liability partnerships (LLP), C-corporations offer limited liability protection to their owners. Owners are not held personally accountable for the corporation's debt, and their personal assets cannot be seized in bankruptcy or due to a legal judgement.

S-corporations and C-corporations differ in a few ways.

• Taxation: An S-corp is a pass-through entity that does not pay corporate taxes. A C-corp pays taxes on its business income and its owners pay personal income tax on their corporate dividends.
• Membership: The internal revenue code caps S-corporation membership at 100 owners. A C-corporation can publicly issue stock and take on an unlimited number of owners.
• Types of owners: The owners of an S-corp must be either individuals, trusts, estates, or non-profits. A C-corp can take on a wider array of investors, including institutional investors such as a mutual fund.
• Class of stock: An S-corporation can only issue one class of common stock. A C-corporation can issue multiple classes, such as Class A shares, Class B shares, common shares, and preferred shares.
• Nationality: An S-corporation must be domestically based, and its owners must be US citizens. A C-corporation can be based anywhere.

A small business owner should consider the myriad filing requirements before they elect S-corporation status.

1. 1. Select a business name. Your S-corp will be a legal entity, and it must have a legal name registered with the government. Some companies have one legal name, but do business under another name. This is called a DBA, which stands for "doing business as."
2. 2. Organize your business as an LLC or a C-corp. In order to elect S-corporation status, a business must begin as one of these two legal entities. File articles of incorporation with your state's secretary of state to establish your business.
3. 3. Obtain an Employer Identification Number and a bank account. The business will need an Employer Identification Number (EIN) from the IRS. It will also need its own business bank account.
4. 4. Create an operating agreement. A business's operating agreement establishes laws and bylaws at the shareholder level. It names ownership stakes, sets limits on the number of shareholders, and sets rules for financial distributions.
5. 5. Name a registered agent for the business. An S-corporation is required to have a registered agent who accepts legal documents and tax documents on behalf of the company. If you are the sole proprietor of your business, you would naturally serve as your S-corp's registered agent.
6. 6. Confirm your eligibility. To enjoy S-corp tax status, you must operate a US-based business owned by American citizens, be limited to 100 total shareholders, have no ownership from institutional investors, not be a bank or an insurance company, and not be an international sales corporation.
7. 7. Name a board of directors. An S-corporation must have a board of directors elected by the shareholders of the business. The board must conduct a minimum of one annual meeting and make minutes available to all owners.
8. 8. File Form 2553 with the IRS. Fill out and submit Form 2553, Election by a Small Business Corporation, to the IRS to establish S-corp tax status. If your business is an LLC that chooses to be taxed like an S-corp, you must file Form 1120-S with the IRS.

The advantages of forming an S-corporation largely come down to taxes and liability protection.

• Avoiding double taxation: S-corporations do not bear a corporate tax liability. In each tax year, they pass their profits along to their ownership group, which means that S-corporation shareholders declare the business's income on their individual tax returns. When personal income tax rates are lower than corporate tax rates, the company saves money overall.
• Limited liability protection: Small business owners that organize as an S-corp are shielded from liability for their company's misdeeds or financial debt. This means their personal assets cannot be seized in a judgment against the business.
• Avoidance of the self-employment tax: An S-corporation can pay Social Security and Medicare taxes on behalf of its owners. An LLC cannot, which subjects those owners to a self-employment tax.

Owning an operating an S-corporation does come with a few disadvantages.

1. 1. Annual fees: Although an S-corp does not pay corporate income tax, most states charge an annual corporation tax that’s sometimes known as a franchise tax. These taxes can be a notable expense if your S-corp is not profitable.
2. 2. Legal requirements: An S-corp has more filing requirements than an LLC or an LLP. It also requires an ongoing board of directors, which must meet at least once per year. Plan to enlist the help of a certified public accountant (CPA), or hire a full-time business manager to operate your S-corp.
3. 3. Limits on ownership: While LLCs and C-corps are permitted to have all types of owners, an S-corp may only have 100 owners. Those owners must be individual citizens, trusts, estates, or nonprofits based in the United States.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by business luminaries, including Sara Blakely, Chris Voss, Robin Roberts, Bob Iger, Howard Schultz, Anna Wintour, and more.