S Corporation Guide

limited liability protection to its shareholders. It is named after Subchapter S of the Internal Revenue Code, which outlines the rules and regulations governing this type of corporation.

The S corporation is specifically designed to meet the needs of small business owners. Accordingly, it can often be a great choice for child care business owners who want to protect their personal assets and lower their tax bill.

Before going into the benefits of an S corporation, it is important to note that throughout this document when we mention an S Corporation, we also mean a corporation or a Limited Liability Company (LLC) that has elected to be treated as an S Corporation for tax purposes. LLCs are state-level corporations. Accordingly, they need to let the federal government know how they want to be treated for tax purposes – as a sole proprietor (a single member LLC), a partnership (a multi-member LLC), or an S or C Corporation. Therefore, all of the processes and benefits of an S Corporation are also available to an LLC that is being treated as one.

Why is it Beneficial?

S corporations provide shareholders (the company owners) with three primary benefits – liability protection, favorable tax treatment, and easy transfer of ownership. Let’s go into these in more detail.

Liability Protection

S corporations provide the benefit of three different types of liability protection which can help protect a business owner’s assets:

• Limited Liability: Shareholders are not personally responsible for the corporation's debts or legal liabilities beyond their investment in the corporation. This means that in most cases, creditors or legal claimants cannot come after the personal assets of shareholders to satisfy the corporation's obligations.

• Legal Entity Status: A corporation is a separate legal entity from its owners, which means that it can enter contracts, own assets, and sue or be sued in its own name. This helps to shield shareholders from personal liability for the actions of the corporation.

• Shareholder Limited Liability: Shareholders are not responsible for the actions of other shareholders or the management of the corporation. Each shareholder's liability is limited to their investment in the corporation.

This is similar to the liability protection offered by traditional C corporations and limited liability companies (LLCs). It enables entrepreneurs to run their businesses while shielding their personal finances and assets from many of the risks and liabilities associated with commercial activities. For example, if the corporation is sued or cannot pay a business debt, the creditors cannot seize the personal bank accounts, homes, cars, or other assets of the individual shareholders to satisfy the obligation.

Favorable Tax Treatment

S Corporations  have some potentially favorable tax rules. An S corporation allows owners who work for the company to take a portion of the profits as salary, while taking the remaining portion as distributions (also called profit).

The compensation for an owner must be “reasonable compensation” that is similar to employees based on their job duties, experience, and hours worked. Reasonable compensation is typically 35-60% of the total compensation for an owner. Reasonable compensation is subject to payroll taxes including Social Security, Medicare, unemployment tax (for a total federal tax of 15.3%). Any reasonable compensation that isn’t taxed is then subject to income tax.

Distributions bypass payroll taxes and therefore are subject to income tax. As a result, the owner saves 15.3% of the money they receive as distributions.

Easy Transfer of Ownership

Third, S corporations have a more straightforward process for transferring ownership interests. Many child care businesses are sole proprietorships. In a sole proprietorship, the owner is the business and there is not a separate entity. Accordingly, selling the business or leaving the estate for a loved one can become complicated. Whereas, shares in an S corporation can be easily sold or transferred to other individuals or entities, facilitating changes in ownership without disrupting the business operations. 

How to Create an S Corporation

There are two ways to get the benefits of an S Corporation. You can either incorporate as an S Corporation. or become a Limited Liability Corporation and elect to be treated as an S Corporation. Both avenues are detailed below.

To form an S corporation, there are five steps that must be completed:

1. Choose a name for your corporation that is not already in use by another business and complies with your state's rules for business names. The name must include a corporate designation like Inc., Corporation, or the abbreviation Corp.

2. File articles of incorporation with your Secretary of State or similar agency in your state. The articles of incorporation typically include basic information about the corporation, such as its name, principal office address, registered agent, purpose, duration, and the number of shares of stock it is authorized to issue. Most states provide forms that lay out the required articles content.

3. Hold an organizational meeting to adopt bylaws, elect officers and directors, and take other necessary actions to organize the corporation per state rules. Bylaws provide the operating framework, including rules for holding meetings, voting procedures, electing officers, and managing day-to-day business activities. If you are the sole owner, you can complete these items independently.

4. Obtain an employer identification number (EIN) from the IRS, which is used to identify your corporation for tax purposes. This is done by filing IRS Form SS-4 and can be obtained online. The EIN is like the corporation's Social Security number for tax filing and reporting purposes.

5. File Form 2553 with the IRS to elect S corporation status. This form establishes your business as an S Corp for tax purposes. The form must be filed within 75 days of the corporation’s incorporation or at the beginning of the tax year for which the election is to be effective. All shareholders must consent to S corporation status on the form. There is no filing fee.

Limited Liability Companies (LLCs) can also elect to be treated as an S Corporation. An LLC is a creation of the state, therefore, for federal tax purposes they can select to be treated as an S Corporation. In this case, you would set up an LLC per your state laws and file Form 2553 with the IRS. This designates you as an S Corporation for tax purposes. LLCs can make this election when incorporated or typically within 5 years of making a tax classification change. If you elect to become an S corporation, you will need to wait 5 years before changing to another form such as a partnership or single member LLC.

How to Manage an S Corporation

Once an S corporation is formed, there are several ongoing responsibilities and obligations for managing it properly:

• Keep business finances completely separate from personal finances. Maintain separate bank accounts and credit cards, and do not comingle funds. To preserve liability protection, accurate record keeping is crucial by tracking assets, liabilities, income, expenses, and equity.

• Hold annual shareholder meetings and maintain detailed meeting minutes. If it is just you, this may be done independently.

• Pay required federal, state, and local taxes in a timely manner, including payroll taxes if the S Corp has employees. Estimate payments for distributions may be required quarterly to avoid underpayment penalties.

• Have written shareholder agreements outlining rights, responsibilities, and ownership transfer procedures.

• File annual reports with state governments, if required.

• Pay reasonable salaries to shareholders who are employees of the corporation. This is important for IRS purposes to justify paying the remaining profits as S Corp distributions.

• Report any changes in ownership structure to the IRS, such as if shareholders are added or removed. Submit an updated IRS Form 2553. Report address changes, contact information for officers, employees, etc.

Finally, make sure you file your taxes. An S corporation does not pay federal income tax at the corporate level. Instead, the income, deductions, and credits of the S corporation flow through to the shareholders, who report their share of the income on their individual tax returns.

An S Corporation has its own tax return, a Form 1120S. The 1120S requires the same type of information as found on a Schedule C, with the addition of details specific to the S corporation structure and its shareholders. The corporation must also keep track of each shareholder's ownership percentage and any changes in ownership that occur during the tax year. For more information on the Form 1120S and S corporation tax requirements, visit the IRS website at https://www.irs.gov/forms-pubs/about-form-1120-s.

Each shareholder receives a Schedule K-1 from the S corporation, which reports the shareholder's share of the corporation's income, deductions, and credits. The shareholder must report this information on their individual tax return, Form 1040.

In addition to federal income tax, the S corporation may also be subject to state and local taxes, including, income tax, sales tax, and employment tax. The requirements for filing state and local taxes vary depending on the state and locality in which the corporation operates.

It's recommended to consult with a tax professional to ensure that you are properly reporting and filing taxes for your S corporation.

Frequently Asked Questions

What should be included in S corporation Shareholder Agreement?

A S corporation Shareholder Agreement should be a written document which addresses topics such as:

• requirements for holding meetings,

• electing officers/directors,

• voting rights,

• dividends,

• buying/selling shares, and

• decision-making authority.

It is important to note that this document must be signed and dated or it must clearly reflect the board meeting at which it was approved.

What should be included in S corporation minutes?

S corporation minutes should include a record of the discussions and decisions made during shareholder meetings as well as:

1. Date and location of the meeting.

2. Names of the attendees, including shareholders, officers, and directors.

3. Approval of minutes from the previous meeting.

4. Reports from officers and committees, including financial reports.

5. Discussion of any new business or proposals brought before the meeting.

6. Votes on any resolutions or decisions made during the meeting.

7. Election of officers or directors (if applicable).

8. Any other business or matters discussed during the meeting.

What are the requirements to elect S corporation status?

To elect S corporation status, a business is required to:

• have 100 or fewer shareholders, 

• only have one class of stock,

• must not have nonresident alien shareholders, and

• must be organized in the U.S. (with some exceptions).

Shareholders are limited to individuals, estates, certain types of trusts, or certain exempt organizations.

What are the advantages of an S Corporation?

Key advantages include liability protection, avoiding double taxation on profits, allowing company losses and deductions to pass to shareholders, and potentially avoiding some payroll taxes.

What are the disadvantages?

S Corporations come with more complex recordkeeping and regulations, including holding formal director/shareholder meetings and putting salary and profit distributions in writing. There are also limits on types of shareholders and number of shareholders.

What should I do if ownership changes?

If ownership changes, you will need to file a Form 2553 with the IRS noting the changes Additionally, you will need to follow up with your state’s Secretary of State and follow their procedures for a state-level recording.