An S corporation is a tax designation that a business must apply for with the Internal Revenue Service. Used for small businesses, the benefit of the S corporate designation is that it allows the business to be taxed as a partnership. To apply for S corporate status, the business must submit a completed Form 2553 within 2 months and 15 days after the beginning of the first tax year that it wants to be treated as an S corporation.
To qualify as an S corporation, a business must either be a corporation or be eligible to be treated as a corporation for tax purposes. As a result, a limited liability company can elect to be an S corporation. The business can have no more than 100 shareholders or members, who must be individuals, estates, exempt organizations or certain trusts. Shareholders cannot be corporations, partnerships or nonresident alien, and the S corporation can only have one class of stock. The S corporation cannot be a bank, insurance company, possessions corporation or a domestic international sale corporation. The business’s tax year must either end on December 31 or end on a date based on a clearly established business purpose. Finally, all of the shareholders must agree to let the business become an S corporation.
If the S corporation starts as a corporation, it will have three levels of management. The corporate officers, such as the chief executive officer, run the day-to-day activities. The officers are hired by the board of directors, who is also responsible for making decisions regarding big picture corporate strategy. The board is chosen by the shareholders at the annual shareholder meeting. Specifics regarding which level of management makes which decisions are generally defined by the corporation’s bylaws, which are the rules that the shareholders agreed to when the corporation was started.
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If the S Corporation is an LLC, it can be structured in one of two ways. A member-managed LLC allows of the business’s owners to make legally binding decisions for the business. This means that every member has a say in how the business is managed, can hire employees and can enter into contracts on the LLC’s behalf. A manager-managed LLC restricts management powers to a few select individuals; unless the business’s owners are selected, they cannot make day-to-day decisions for the business.
The chief benefit of being an S corporation is that the business is taxed as a partnership. This means that instead of the S corporate entity being taxed and then its shareholders being taxed whenever the business makes a distribution, the shareholders pay taxes on the business income as it is earned. For example, if there are four shareholders with an equal stake in an S corporation that earned $100,000 for the year, each shareholder would report $25,000 of income on his tax return.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.