This is the first post in a series of posts about S-Corps. We’ll explain what exactly is a “S-Corp” and how they came to be, when you should consider electing S-Corp status (read that here), and how you can reduce your tax liability by making an S-Corp election (read that here).
A Summary of Business Entities & Taxation
Historically, entrepreneurs only had two options to form a business entity (we will ignore LLCs for a moment, which are only a few decades old):
- Option 1: Form a general partnership and (a) benefit from a reduced tax bill due to “pass-through” taxation, but (b) be subject to full personal liability for all business debts and liabilities; or
- Option 2: Form a corporation and (a) benefit from limited personal liability for the business’ debts and liabilities; but (b) be subject to a higher tax bill due to “double-taxation.”
Obviously, neither option is ideal. One will result in more income but higher risk, the other will result less risk but lower income.
A Middle Ground – The “S-Corp”
In the 1950s President Eisenhower led the charge to make a middle option: allow a corporation to “pass through” its income while still benefiting from the limited liability associated with corporations. And in 1958, Congress agreed and enacted Subchapter S of the IRS Code.
As a result, business owners can form a corporation and make an S-Corp election and receive a lower tax bill and limited liability.
But here’s something important to remember – an S-Corp is not a business entity. When you form your business entity with your Secretary of State, you can choose a partnership, limited liability company, corporation, or non-profit corporation. But you cannot choose an “S-Corp.” That’s because it is merely a tax classification.
It is very important to note that there are specific requirements you must meet if you want to take advantage of S-Cop taxation. And they are not ideal for many businesses, especially high-growth potential startups that want to raise venture capital.
According to the IRS, to qualify for S-Corporation status today a corporation must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
S-Corps 101 (Part 2): Should Your Business Make an S-Corp Election
Next week we will dive into whether your business should make an S-Election and explain why high-growth startups should not make an S-Election. (Read that post here.)