If you are starting a business, it is important to decide how you want to organize your business so that its structure offers you the best possible outcomes when it comes to your money. So far, we’ve addressed the sole proprietorship and the LLC. In this third and final installment looking at three popular business organizations, we will take a brief look at the S-Corporation.

What is an S-Corporation?

An S-Corporation is a regular corporation with special privileges. It is considered a “regular” corporation, like a C-Corporation, but with a very important difference: An S-Corporation is a pass through entity for tax purposes. This means that profits pass through the company, and the S-Corp is not taxed as its own entity, avoiding the double taxation that a C-Corp is subject to. However, there are some cases that an S-Corp experiences income taxation at the corporate level, such as certain capital gains and passive income, but, for the most part, shareholders are taxed for their shares on their 1040s.

Realize, though, that even though you can retain profits for the S-Corp as operating capital, this can be a problem for shareholders. All profits are considered as though they have, in fact, been distributed amongst shareholders. If profits are retained by the S-Corp, this can result in a situation where shareholders are taxed on their share of the profits – even though they didn’t receive the income.

In order to be taxed as an S-Corp, you must notify the IRS within a certain amount of time. You must file a Form 2553 in order to qualify. Here are some of the other criteria of the S-Corp.:

• Corporation must be domestic.
• Limit of 100 shareholders. (Members of a family can be treated as one shareholder for the purposes of the IRS test.)
• Shareholders can only be U.S. citizens, or resident aliens.
• Shareholders are limited to individuals, estates, some exempt organizations and certain types of trust.
• Shareholders must each consent to the S-Corp. election.
• The corporation only issues one class of stock.

Banks and thrift institutions with some method of accounting for bad debts (Section 585) are ineligible to be S-Corps or convert to them. Other ineligible corporations include DISCs (domestic international sales corporation), insurance companies subject to IRS Code subchapter L, and corporations that use Section 936 to be treated as possessions corporations. There are also requirements associated with the tax year used to convert to an S-Corp.

Forming an S-Corp

If you want to form an S-Corp, you will need articles of incorporation, along with resolutions and by-laws. You will need to accomplish this in the state where you plan to conduct most of your business. After verifying that your S-Corp meets the eligibility requirements, it is time to file the Form 2553. Every shareholder needs to sign this form, and it must be filed by the 15^th day of third month after the incorporation date.

You will want to set up payroll information, and you may need it when you prepare your taxes. It is a good idea to consult with a knowledgeable tax attorney or accountant as you set up your S-Corp. As an S-Corp, you can provide benefits for employees, setting up retirement plans and arranging for health benefits.

An S-Corporation is idea for small business owners who plan to expand to some degree, but limit their shareholders. It is ideal for those who are interested in the tax benefits of a pass through, but want an actual corporation that is a little more formal in structure than the LLC. You can covert your S-Corp to a C-Corp later if you decide you want to issue more stock (or classes of stock), or if you want to overcome some of the other limitations set by a S-Corp.