Readers who are partners in an incorporated business may have heard of “S corporations” and that they enjoy a unique tax structure. The Small Business Administration has a lot of good information about S corporations, which we will summarize here.
Also known as an S corp, an S corporation is a type of business organization in which profits and losses flow directly to the shareholders. This allows the business to avoid paying taxes; instead, the shareholders take care of it through their own personal income tax returns.
This is similar to general partnerships, as we discussed in our previous post. But shareholders in an S corp who also works for the business must be paid “reasonable compensation,” unlike in a general partnership, in which the partners are not allowed compensation on top of the profits. “Reasonable compensation” usually means fair market value.
The IRS has several requirements for businesses that wish to form as an S corporation. First, the business must file as a corporation. Then, the shareholders must all sign and file a form called Form 2553. This elects the corporation to become an S corporation.
After that, your business likely must obtain licenses and permits. Which permits and licenses are required depends on your location and the type of business the corporation conducts.
The advantages of forming an S corporation over a traditional, or C corporation, include tax savings and possible tax credits for business expenses, while still creating an independent life for the business. On the other hand, S corps have stricter operational processes, and the IRS carefully watches the compensation shareholders receive to ensure that it is “reasonable.”
Whether an S corporation would work for you is something to discuss with your attorney.
