An S Corporation is similar to a C Corporation, and outside of a few differences, the steps for setting up both entities are pretty much the same. What makes an S Corp different is its pass-through tax status, which the business selects once the corporation is formed. Instead of standing as a separate corporate entity, profits and losses pass through to shareholders' personal income tax returns. The Internal Revenue Service has strict requirements and an annual filing deadline for electing an S Corp tax status.
Research IRS Requirements
An S Corp differs from its C Corp counterpart in the number and type of its shareholders, and in the class of stock the business can issue. According to IRS regulations, an S Corp can’t have more than 100 shareholders. Each one must be both an individual rather than a business, as well as a legal U.S. resident. In addition, an S Corp can only offer one class of stock so that all shareholders have equal voting rights and share in profits and losses based on their ownership percentages.
Create the Corporate Structure
Contact the Secretary of State for the state in which you plan to incorporate for corporate formation rules specific to your state. Although details may differ between states, the process is similar in all of them. It typically involves choosing a unique business name, appointing a board of directors, filing Articles of Incorporation and creating corporate bylaws. The next steps involve holding an initial board of directors meeting, issuing stock and obtaining all necessary business licenses and permits.
Shareholder Wages vs. Distributions
When setting up payroll and deciding on wages, keep in mind that with an S Corporation, all shareholders who work for the company must receive fair market wages. This rule is in place to prevent the business from avoiding its payroll tax obligation by minimizing or eliminating shareholder-employee compensation in favor of stock distributions. Violating this rule can result in the IRS reclassifying distributions as wages and imposing severe tax penalties.
Elect an S Corporation Tax Structure
Complete and have all shareholders sign IRS Form 2553 to elect an S Corporation tax structure. So that the election takes effect in the current tax year, the deadline for filing is no more than two months and 15 days after the beginning of the year. Otherwise, the election won’t take effect until the next tax year and the IRS will tax the business as a C Corporation for the current year. However, the IRS does provide some relief for late filings if you can show that failure to file on time was due to "reasonable cause." The IRS notes a number of reasonable exceptions in the instructions for Form 2553.
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