You've heard the word "corporation" for years, and the first thing that probably comes to mind is a huge business with hundreds of employees that sells goods and services all over the country or the world. True, there are many such corporations. But, your business doesn't have to be huge in order for you to form a corporation.
In fact, one type of corporation, called an "S-corporation" or "S-corp," is a common form used for new small businesses. An S-corp is almost exactly the same thing as a regular corporation, which is known as a C-corporation or "C-corp." The major difference is in how the two types of corporations are taxed.
If you're thinking of opening a small business, you should consider some of the advantages-- and disadvantages-- of using the S-corp form for the business, and you should know some things about how they're formed and how they work.
What's an S-Corporation?
An S-corp is basically the same thing as a C-corp except that the S-corp has elected a special federal tax status, namely, S-corporation tax status. The election is made by filing Form 2553 with the Internal Revenue Service (IRS). So, what exactly does S-corp status mean?
It means that the corporation will be treated like a partnership, limited liability company (LLC) or sole proprietorship for tax purposes: business profits and losses "pass through" the corporation directly to the owners or shareholders, who in turn report the profits and losses on their individual tax returns.
A regular C-corporation is taxed much differently; in fact, there's "double taxation." A C-corp must pay taxes on the corporation's profits, and then the shareholders or owners have to pay taxes on money they receive from the C-corp, such as salaries or stock dividends.
Perhaps the biggest advantage of choosing a corporate form for your small business is the "limited liability" you'll have. Just like any other corporation, an S-corp will shield you from personal liability for the corporation's debts and obligations. So, if the corporation defaults on a bank loan, the bank can't come after your house or car for repayment of the loan.
There are exceptions to the limited liability, however. Some instances when you can be personally liable for the corporation's debts and obligations include:
- If you personally guarantee repayment of a loan to the corporation and the corporation fails to repay it
- If you personally cause an injury to someone else
- If you fail to withhold federal taxes from your employees' pay checks and/or fail to pay the taxes to the IRS
Forming & Managing an S-Corp
An S-corporation is formed the same way any other corporation is formed. Exactly how a corporation is formed is set by the laws of the state in which you form the corporation, that is, where you "incorporate," and the requirements vary from state to state. Generally, however, you have to:
- Write articles of incorporation, which contain information like the S-corp's name, business address, and the name and address of the corporation's "registered agent," that is, the person who will accept important documents on behalf of the S-corp, such as legal and tax documents. The articles of incorporation have to be filed with the appropriate state official, which is usually the secretary of state, for the state where you incorporate.
- Write corporate bylaws, which detail how the corporation will run, that is, when meetings will be held by the board of directors or for the shareholders, voting procedures for business decisions made by the corporation, the number of officers and directors, and how and where the S-corp's business records will kept.
- Apply for an employer identification number (EIN), which the IRS uses to identify the corporation. In addition, you might also need a state identification number, so be sure to check the laws in the state where you incorporate.
Not all states recognize S-corporations, so you might not be able to form your S-corp in the state you want. Also, some states will tax an S-corp the same way as a C-corporation. So, it's vital that you check the laws in the state where you want incorporate, or get some help from an experienced business law attorney.
An S-corp must follow some rules in order to keep its corporate status. If you don't follow the rules, you could lose the S-corp tax benefits, or even worse, you could lose the limited liability for the S-corp's debts and obligations. Some of the rules to follow include:
- Holding annual meetings of the corporation's shareholders and directors.
- Making accurate records of all shareholders and directors meetings, as well as all business decisions made by the board of directors.
- Filing corporate taxes.
- Keeping accurate financial records.
- Making sure that the shareholders, officers and directors keep their personal assets, like money and real estate, separate from the corporation's assets. In short, don't share bank accounts.
Questions for Your Attorney
- Why should I form an S-corporation and not a limited liability company (LLC)?
- How many directors, officers and stockholders does my S-corp have to have?
- How much will it cost to set-up my S-corp, and how long will it take?