S Corporation Regulations: Everything You Need to Know

S corporation regulations provide numerous tax benefits for their shareholders.3 min read

S corporation regulations provide numerous tax benefits for their shareholders. According to federal income tax laws, S corporations are specially taxed by the IRS. S corporations are considered separate entities from their individual shareholders, which allows these shareholders to benefit from limited liability.

The IRS requires S corporation owners to pay employment taxes, also known as self-employment taxes, of 15.3 percent in order to fund Medicare and Social Security benefits. If an owner wishes to pay less in taxes, he or she can take less money in their salary and take more money in distributions, for which the self-employment tax does not apply.

The IRS requires owners' salaries to be “reasonable.” If an S corporation accountant makes a $200,000 salary and receives distributions of more than $200,000, the IRS might not consider the salary reasonable. If this happens, the IRS will require that owners pay employment taxes on their distributions instead of their salaries.

S Corporation Benefits

S corporation shareholders report annual profits on their individual tax forms, which is then taxed as regular income. Thanks to this special taxation, S corporations are not required to pay any federal income taxes to the IRS. However, a corporation's debt, losses, and income are all divided and distributed to its shareholders. Through this distribution, shareholders report the income or loss on their individual tax forms. This process is called single taxation, and it allows an S corporation to benefit from a unique taxation model. This limits individual liability through diversifying it.

S corporations may deduct business-related expenses on their tax returns, such as equipment purchases, operating costs, and health insurance. However, employees who own more than two percent of the business will have their fringe benefits taxed. Owners can also write off net operating losses, although losses must not exceed the amount of their investment.

Although there are benefits to becoming an S corporation, depending on your jurisdiction, these benefits might not even apply. Depending on the state, different taxation rules and regulations may apply to S corporations. For example, Washington State doesn't even recognize S corporations as their own distinct category and instead treats all corporations as regular corporations.

Becoming an S Corporation

A qualified existing corporation may choose to become an S corporation, which changes their tax according to the terms with Subchapter S of the U.S. Tax Code. Like other types of businesses, S corporations must withhold taxes from employee's paychecks. S corporations must match their employees' Social Security and Medicare taxes owed to the IRS.

A corporation must meet the following requirements in order to become an S corporation:

  • Only domestic corporations may choose to become S corporations. This includes insurance companies, joint-stock companies, and associations. However, certain types of domestic corporations are ineligible to elect to become S corporations, including domestic international sales corporations, members of affiliated groups of corporations, corporations utilizing the Puerto Rico and possessions tax credit, and insurance companies and banks taxed under Subchapter L of the Internal Revenue Code.
  • The corporation must not have more than 100 shareholders in order to be eligible for S corporation status.
  • Shareholders must be legal residents of the United States.
  • Shareholders must be “natural persons,” that is, they must not be corporate shareholders and partnerships. Some estates and trusts are eligible to be shareholders of an S corporation, but when it comes to calculating the actual number of shareholders, estates and trusts may not be counted.
  • All shareholders must give their consent in order for the corporation to elect to become an S corporation.
  • The corporation must only have one class of stock, which means that all stock is worth the same amount. No stock has more of a claim on the earnings of the company than other stock. In other words, if you own 10 percent of the company's stock, you'll receive 10 percent of the company's profits, losses, and credits. Keep in mind that an S corporation can still issue voting and nonvoting shares, as these are not considered two different classes of stock.

To become formally recognized as an S corporation, qualified domestic corporations and LLCs must submit Form 2553 to the IRS. Additionally, they must report their elections within 75 days of the next tax year in order for the change to become effective that year. You can locate Form 2553 under the “Forms and Publications” section of the IRS website.

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