Small businesses are at the heart of the American economy, contributing revenue to the country and benefiting workers themselves too. It is becoming an established path, particularly in the wake of COVID-19, for workers to make a switch to this more independent career, which often leads to more fulfilment and motivation at work. However, with all the excitement and opportunity associated with starting a business, it can also be a complicated experience.
This complexity is present right from the get-go too, with the establishment process of most business structures proving more than a nuisance to a lot of entrepreneurs. One business entity that has proven particularly tricky to establish is an S-corp (or S-corporation). S-corps are LLCs that have elected this Internal Revenue Service (IRS) tax classification in order to be eligible for certain benefits. This article will explore when it is appropriate for LLCs to consider making this switch, alongside how they can do so.
When To Choose An S Corp
For almost all entrepreneurs, it is recommended that they establish their business as a limited liability company (LLC) because its benefits are perfectly suited to the vast majority in this situation. That being said, there are certain specific scenarios in which it will be more beneficial for LLC owners to choose S corp status.
This relates to the difference in how these two tax delegations are liable for tax. For tax purposes, standard LLCs are referred to as pass-through entities. This means that the business’s profits are exempt from tax, but business entity owners must pay personal income tax on their share of business profits, plus self-employment tax.
Contrastingly, S corps can reduce the amount lost to employment taxes by spreading earnings among members and shareholders. This is the case because the owners of the company are considered ‘employees’ if they are paid a “reasonable” salary for their position and industry.
How To Establish One
IRS Requirements
The IRS stipulates certain minimum criteria that businesses must meet in order to be eligible to decide to become an S corp. These are as follows:
- A minimum of 100 shareholders
- Must be a domestic corporation
- Must only supply a single class of stock
- Shareholders can only be U.S. citizens or permanent residents
- Must be owned by private individuals, or certain trusts/estates
- Must be a unanimous agreement between shareholders to become an S corp
- A board of directors must be assembled
Formation Process
Since S corps are a tax designation that can be elected by certain business structures, the only way to form an S corp is to establish one of these business structures and then file Form 2553 to elect S corp status. The two business structures that can elect to become an S corp are LLCs and corporations.
It is recommended in almost all cases to opt for an LLC over a corporation if you intend to elect S corp status. This is because all of the advantages of a corporation would be nullified by the restrictions of S corp tax status. Additionally, LLCs are far easier and cheaper for businesses to keep up than corporations, which is an important consideration.
Copyright: TRUIC
As a result of the above considerations, the process for forming an S corp is as simple as establishing an LLC and electing S corp status. There are five basic steps to this process: naming your LLC, choosing an RA (registered agent), submitting the Articles of Organization, creating an Operating Agreement (which is normally optional), and getting your business an EIN.
Once all of this has been completed, simply file Form 2553 with the IRS to become an S corp. Note that each of the above steps has its own set of requirements (which do fluctuate depending on your state). For a more in-depth look at the requirements associated with each step of an LLC’s formation process, please refer to The Really Useful Information Company’s (TRUIC) resource on the topic of how to start an s corp.
Closing Remarks
On balance, there are a lot of factors to consider when deciding whether to become an S corp or not. Hopefully, after this article, the difficulty of the process will no longer be one of them.
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