When you set up your business, you choose from several types of business structures. The structure you operate under affects your tax liabilities, so selecting the right one for your business is crucial. Forming an S Corp is one business entity option. Knowing how to form an S corporation helps you decide how you will organize your business.

What is an S Corp?

An S Corp is a business structure that makes the company a separate legal entity from its owners. S Corps are also called S corporations, and the owners are called shareholders. You can elect to operate as an S corporation through the IRS. By doing so, you avoid double taxation. The shareholders are only taxed, not the corporation.

For many small businesses, forming an S corporation is a smart choice. By becoming an S Corp, you avoid double-taxation that regular corporations are subject to. But, you are protected by the limited liability of a corporation.

How to form an S corporation

The following is an overview of how to form an S Corp. Take a look at your next steps in setting up an S Corp.

Form 2553 to elect S Corp Status

Before becoming an S Corp, you have to first form a C corp. Once the business is a corporation (C corp), all the owners must sign and file Form 2553 to elect S Corp status.

Form 2553, Election by a Small Business Corporation, needs to be filed within 75 days of forming the business. Or, the form must be filed within 75 days of the new tax year. The IRS will either accept or deny the election. Your business will be notified by the IRS in writing.

State and local tax agencies may require you to file additional forms. Check with your state to find out your specific requirements.

When you make an S Corp election, you must name your business. The name needs to be unique to your business. You can add “Inc” or “Incorporated” to the end of your business’s name once the S Corp is registered.

You are not required to hire an attorney when electing to operate as an S Corp. But, an attorney can offer legal advice and help you make decisions for your business.

Articles of incorporation for an S Corp

File articles of incorporation with your state when forming an S Corp. Articles of incorporation are documents that provide formal details about the business.

The documents include information such as:

• The business’s name and address
• Shareholders, directors, and officers
• The business’s purpose
• The amount of stock that will be issued

Each state has different requirements for filing articles of incorporation. Check with your state to find out what forms and information you should include. An attorney can help you prepare and file the articles of incorporation.

Business permits

After you are registered as an S Corp, you need the correct business licenses and permits. Types of business licenses you might need include a general business permit, health permit, and land permit.

Each state has its own laws for business licensing. Your business’s industry might also require special licenses and permits.

S Corp responsibilities

Though there are many benefits to operating as an S Corp, you have more responsibilities than an owner of a sole proprietorship or partnership. The government sets rules for S corporation reporting.

S corporations must file reports every year with their state showing profits and losses. S Corps also pay franchise taxes. Franchise taxes are state fees and are not the same as taxes in franchise accounting for a franchise (e.g., Burger King).

S Corps cannot have more than 100 shareholders, or owners. Only U.S. citizens and permanent U.S. residents can be shareholders. You must establish leadership roles among shareholders and hold documented director meetings.

Compensation

Shareholders can receive both wages and distributions as compensation. Wages and distributions are taxed differently, so you need to know which you should be paid.

S Corp reasonable compensation

If you are a shareholder who works in the business, you must be paid a reasonable amount of wages. The IRS sets standards for what an S Corp reasonable salary should look like.

An S Corp owner’s wages are subject to employment taxes. The S corporation pays FUTA (Federal Unemployment Tax Act) taxes on the wages. The S Corp also pays the employer part of FICA tax. FICA tax includes Social Security and Medicare taxes. The employee part of FICA tax is withheld from the owner’s wages.

Unlike wages, the shareholder’s distributions are not subject to employment taxes. Instead, lower corporate tax rates are applied.

Reporting a low salary and high distribution wages is an IRS red flag. If the IRS decides you should receive more wages and fewer distributions, you might owe more taxes.

S Corp tax structure

S Corps use a pass-through tax. With the S Corp pass-through structure, profits and losses flow through the business to shareholders. The business is not taxed at the federal level. The shareholders are taxed on their personal returns for business income.

S corporation taxes are filed annually. The business files Form 1120S to report profits and losses. Each shareholder receives Schedule K-1 from the S Corp. Shareholders use Schedule K-1 to report profits and losses on their personal tax returns.

In an S Corp, owners are protected by limited liability. If the business cannot pay its debts, owners are not personally liable for them. The shareholders’ property is protected and cannot be used to pay business debts.

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This article is updated from its original publication date (7/31/2013).