What Are the Qualifications for an S Corporation?
Many small businesses in the United States meet the requirements to obtain an S-corporation status for federal tax purposes. This filing status allows corporations to pass corporate income, profits, and losses to individual shareholders and forgo corporate income tax on the company's business profits. Understanding the S-corporation qualifications will help you decide whether this tax classification might be right for you.
Who Can Form an S Corporation?
Any adult who is a citizen or legal resident of the United States, District of Columbia, or a United States territory—and doesn't head an ineligible corporation—can form an S corporation. Ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations (exporters of U.S. goods).
Who Can Be a Shareholder in an S Corporation?
The shareholders of an S corporation can be:
Individuals
Specific trusts and estates
Certain tax-exempt organizations
Corporations, partnerships, and nonresident aliens cannot be shareholders in an S corporation. If an S corporation sells stock to a business entity, it could lose its S-corporation status and be reclassified as a C corporation.
How Many Shareholders Can an S Corporation Have?
An S corporation can have up to 100 shareholders with no minimum number of shareholders. Corporations with more than 100 shareholders can only be C corporations for tax purposes.
What Type of Stock Can an S Corporation Have?
An S corporation can only have one class of stock and that is "common stock." S corporations have to allocate distribution and liquidation proceeds according to the basis of each shareholder and can't issue preferred stock.
Differences Between S Corporations and C Corporations
All corporations, by definition, have shareholders and a separate identity to the corporation’s owners and employees. However, there are a few differences between S and C corporations, laid out in the relevant subchapters in the Internal Revenue Code (subchapters S and C, respectively):
S Corporations Avoid Double Taxation
Whereas a C corporation pays taxes on both business income and distributions, an S corporation is allowed to pass corporate income and loss to its shareholders who pay income tax on these distributions. This avoids double taxation. However, S corporations still have to pay taxes on certain built-in gains and passive income.
S corporations may be taxed the same way as C corporations at the state level or may be treated differently. An S corporation located in Jacksonville, Florida, for example, will pay the standard Florida state taxes (sales and use tax, payroll taxes) and must file a Florida Corporate Income Tax return if it pays federal income tax on Line 22c of Federal Form 1120S. As with other business types, a small business accounting services professional can help you understand and navigate your federal and state tax liability.
C Corporations Can Be International
An S corporation has to be a domestic corporation whereas a C corporation can be international. This makes an S-corporation status especially suited to small, local businesses that want the legal protection of an incorporated business structure.
C Corporations Have Fewer Shareholder Qualifications
Whereas S-corporation shareholders must meet certain requirements, anyone can own shares in a C corporation, including business entities and non-U.S. residents. C corporations can also issue more than one kind of stock and give some shareholders preferred stock.
Differences between an S Corporation and a Sole Proprietorship
The main differences between an S corporation and a sole proprietorship relate to the management structure and the categorization of income for tax purposes. When a business owner is a sole proprietor, he or she pays federal income tax and self-employment taxes on 100% of his or her net income.
By forming an S corporation, this same business owner can categorize a much smaller proportion of net income as "reasonable salary" and pass through the rest of the earnings to shareholders as distributions. The business owner will then pay self-employment taxes on the portion of income characterized as a reasonable salary instead of on the whole amount.
Tax Forms that S Corporations Have to File
To receive S corporation status, a corporation must file Form 2553 Election by a Small Business Corporation signed by all of the shareholders. The corporation and shareholders will then need to file the following forms with the Internal Revenue Service by March 15 following each tax year:
Corporation
Income tax return - Form 1120-S(corporation) and 1120-S K-1(individual shareholder)
Estimated tax - Form 1120-W
Employment taxes
Federal unemployment tax - Form 940
Excise taxes, for relevant industries
Shareholders
Income tax - Form 1040 or 1040-SR and Schedule E, plus any other relevant forms listed on the shareholder's Schedule K-1
Estimated tax - Form 1040-ES
Meeting S Corporation Qualifications Could Result in Significant Tax Savings
The filing requirements for an S corporation are very specific and must be done correctly in order to preserve this special tax status.
However, if your corporation qualifies and requests S-corporation status before the start of a given calendar year (or by 15 March at the latest), you can enjoy significant tax savings and several other S-corporation benefits.