Definition of an S Corp Shows Most Important Feature

Written by Wesley Henderson

February 9, 2021

Harry and Lloyd want to open a worm shop called “We Have Worms.” They want to go in 50/50 on everything – money invested, time devoted to operating the business, marketing, and all the rest of it. They’ve heard about “write-offs” and definitely want to take advantage of reducing taxes. They also want to make sure they can take home bonuses if the worm business really takes off. 

What options do Harry and Lloyd have? One option is setting up an LLC and filing as an S-Corporation (S-Corp). Below is a brief description of S-Corps and how business owners use them. 

Definition of an S-Corp?

At its most basic level, according to Blacks Law Dictionary, the definition of an S Corp is “a corporation whose income is taxed through its shareholders rather than through the corporation itself. Only corporations with a limited number of shareholders can select S-Corporation tax status under Subchapter S of the Internal Revenue Code.” 

The IRS describes the S-Corp like this: “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.” 

Furthermore, the IRS advises all S-Corps must meet the following criteria: 

  • They must be a domestic company 
  • Shareholders should be individuals, estates, or certain trusts – but not partnerships, corporations, or non-residents
  • S-corps cannot have more than 100 shareholders
  • They can have only one class of stock
  • Not classify as an “ineligible corporation” under the code

In our example with Harry and Lloyd, it might sense for them to set themselves up with a S-Corp. In order to do it, they must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders. 

Shareholders may also have to distribute bonuses equally. Most people starting business have a tax advisor, so if you don’t, contact one to make sure you understand the tax implications of S-Corps. 

Should you set up an LLC or S-Corp? 

When researching entities for your new business, you may run into conversations about whether you should set up an LLC or an S-Corp. Well, it’s a bit of a misnomer because an S-Corp is actually a tax filing under the election mentioned above. So, it is not necessarily either/or. For example, an LLC can file as an S-Corp and a Corporation can file as an S-Corp. In other words, you can gain the benefits of the S-Corp either by filing an LLC or Corporation. To be clear, you can set up an LLC that files its taxes under the S election, so you can get the benefits of the S election without having to go through the formalities of an actual corporation. 

For Harry and Lloyd, it’s likely that a tax professional would recommend that exact setup in a situation like theirs – an LLC that files as an S-Corp. The LLC offers them flexible management options and allows them to select the S-Corp for tax purposes. As long as they have submitted for 2553 and have drafted an operating agreement that specifies how the business will operate, Harry and Lloyd likely have the necessary legal documents to proceed with selling worms. They will likewise enjoy the maneuverability in management structure they need to custom their bruins to their unique personalities. 

The LLC will provide Harry and Lloyd with a liability shield, as well. They must avoid commingling personal funds with the business operating account, but otherwise they have a level of protection should something unexpected happen. 

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Primary Benefit of an S Corp

The main benefit of an S Corporation for owners is the ability to reduce the amount of taxes that the owners pay on their income. Owners in an S Corporation can be paid both a salary and dividends. When properly balanced, an owner can then save on the total tax bill because payments made to the owner as a dividend are not subject to all the taxes other payments are subject to (namely, owners do not have to pay self-employment taxes). There are some limitations, so you should contact a tax professional prior to making the S election. 

Should you file as an S Corporation?

If you and your business are remotely similar to Harry and Lloyd, you should contact a tax professional to make sure you have the right tax setup as it very well could put more money in your pocket (even after paying the tax professional). The first step though is filing the LLC. You can make the S election later. 

Conclusion 

The S-Corp’s most important feature is its pairing with an LLC.  With an LLC, the shareholders/owners enjoy massive liability protection and the flexibility most small businesses desire…as well as the coveted lowered tax bill.

If you are ready to set up your LLC, look no further than Drafted Legal. Drafted not only can set up your LLC but also provide you with templates to protect your business.

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Wesley Henderson

Hi, I'm Wesley! A business attorney turned entrepreneur devoted to simplifying how you protect your business and your assets. Like you, I'm an business owner so I get it and I started Drafted Legal to help you put in place simple and sound legal strategies so you can focus on your business and not worry about getting lost in legal nuances.

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