An S Corporation is essentially a regular corporation electing a pass through status with the IRS (for income, losses, deductions and credit). To qualify for S Corporation status, the corporation must meet the following requirements: (i) be a domestic corporation; (ii) have only allowable shareholders (individuals, certain trusts and estates) and cannot include partnerships, corporations or non-resident alien shareholders; (iii) have no more than 100 shareholders; (iv) have only one class of stock, and (v) not be an ineligible corporation (certain financial institutions and insurance companies cannot elect “S” status).
Advantages. So long as formalities are followed, an S Corporation is an effective shield of liability, and shareholders will only be liable for debts, obligations and liabilities of the Corporation up to the amount of their investment. Profits and losses flow through the corporate entity to the shareholders. If a company does not need venture capital funding right away, it may be appealing to set up because losses can be written off on the tax returns of the shareholders up to the amount of your investment. Any shareholder who works for the company has to pay themselves a “reasonable salary,” which is subject to employment tax. Any other income is treated as a distribution, which may be tax free or taxed at a lower rate.
Disadvantages. One of the biggest disadvantages of an S Corporation is the ownership limitations since shareholders may only be U.S. citizens, permanent residents or eligible trusts and estates. A shareholder must also receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You may also be required to pay a higher employment tax in the event of an audit. Additionally, S Corporations are only allowed one class of stock – although S Corporations are allowed stock with different voting rights so long as the ownership of the stock is treated the same. Similar to a C Corporation, there are certain documents and requirements when you set up an S Corporation including Articles of Incorporation, Bylaws, a board of directors, annual meeting requirements, maintenance of separate bank accounts, records and books. In general, you have 75 days after the formation of your corporation to elect S Corporation status.
Assuming you meet the shareholder eligibility requirements, if you want strong protection against personal liability along with pass-through tax treatment and you don’t need the flexibility of an LLC, then the S Corporation is likely the right choice for you.
Melody Ashby is a Senior Attorney at Meyer Law, one of the fastest growing law firms in the United States. Melody helps companies with corporate and securities matters, trademarks, contracts, employment matters and capital raises. Melody is a mentor at tech incubators and accelerators across the United States. Learn more about Meyer Law here on our website + follow us on Instagram @loveyourlawyer