Starting a business is one of the biggest and most exciting steps in one’s entrepreneurial journey. In this article we will look at some of the formalities that so many entrepreneurs are wondering about. Naturally, seeking professional advice is the best way – but if you are busy gathering information as things shape up, this is a great start.
When you’re at a stage past drafting your business proposal — when you are trying to design a new logo, think of a great name, choose a business structure — admittedly, it is all a bit much. So let’s focus for a moment on the structure of a new business. You probably heard of LLC’s, but what about S corporations?
The US Small Business Administration states that S corporations which are also known simply as S corps are a special type of corporation that is designed to avoid double taxation. S corporations allow profits and losses to be passed through to the owner or owners personal income statement so that they are not subject to tax at the corporate level. This is known as pass-through taxation. The SBA also notes that not all states tax S corporations in an equal manner but most do and recognize S corporations in the same way that the federal government does and levies taxes in accordance with this. Some states do not recognize the election of the S corporation status and treat the business as a C corporation while others tax S corporations on profits above a certain limit.
What Entrepreneurs Should Know About S Corporations
The S corporation is a tax classification created by the IRS to help small businesses avoid the process of double taxation. Double taxation is when corporate income is taxed once at the corporate level and then once more at the personal level. This can be avoided by pass-through taxation as was discussed previously. This is the major benefit of S corporations and why many entrepreneurs seek to achieve S corporation status.
The S corporation status is commonly applied to LLCs and C corporations. However it is recommended that an entrepreneur use an LLC because the S corporation requirements can nullify many of the benefits which a C corporation offers over an LLC. There are several requirements that a business must meet in order to become eligible for S corporation status. These requirements were put in place so that large corporations could not benefit from S corporation status and void the purpose of the S corporation.
The requirements to become an S corporation are relatively straightforward. A business cannot have more than 100 shareholders and all of these shareholders must be residents of the US. Additionally a business cannot have more than one type of stock. A business must be owned by private individuals and not other businesses. Finally, a business must be a domestic LLC or corporation if it wishes to apply for S corporation tax classification.
In order to apply for S corporation status a business must fill in form 2553 with the IRS when the business is applying for its Employee identification Number. An EIN is like a social security number but for a business instead of an individual. A business can also apply to become an S corporation after they are incorporated but the timelines for this process are very strict. A business wishing to become an S corporation in the following year can apply any time during the previous year. A business wishing to become an S corporation in the current year must submit this application before the end of March. Otherwise, they will not be able to become an S corporation in that year, even as they learn how to look smart.
There are five basic steps to start an S corporation. The first step is to name a business which would be recommended to be an LLC because this business entity gains the most advantages from becoming an S corporation. The second step is to choose a registered agent. This is the person or company that receives documents on behalf of the business from the state. The third step is to file the Articles of Organization. The fourth step is to create an operating agreement which defines how the business will be run. The fifth step is to obtain an EIN and file Form 2553 to elect the S corporation tax status with the IRS.
For more information this resource covers everything an entrepreneur needs to know about how to start an s corp.
Entrepreneurs are drawn to the S corporation because of the ability to avoid double taxation through pass-through taxation. This has the potential to save small businesses and their owners a great deal of money each year on tax. While these benefits will not necessarily apply in every state, those that do will enjoy significant tax savings. It is recommended that a business should be generating at least some profit on an annual basis and pay at least $20,000 in distributions before considering becoming an S corporation.