What is an S-Corporation?

The letter S laying on concrete, symbolic of answering the question: what is an S-corporation?

Everything You Need to Know About S-Corporations

If you’re in business, you’ve heard of S-corporations (or S-corps). You probably even have a lot of people in your life that have strong opinions on whether you should be an s-corporation or not.  But what exactly is an S-corporation and how does the structure affect how you run your business? Or, simply put: what is an S-Corp?

S-corporations entered the small business scene in 1958 when the federal government passed legislation allowing their formation.  Now, by IRS estimates, there are over 5 million S-corporations in existence. Read on to learn everything you need to know about S-Corps.

Benefits of Forming an S-corporation

Pass-Through taxation.

One of the biggest benefits of s-corporations is that the taxation of the company’s profit passes through to the owner.

In a regular corporation (or “C-corporation”), the business’ profit is taxed at the business level.  If the shareholders want to take money out of the company, they must either do so by taking a salary which is subject to payroll taxes or taking a dividend.  In the case of a dividend, that income has already been subject to the corporate tax rate and then is taxed again on your personal return.  The income being taxed on the corporate level and personal level is known as double taxation.

In an s-corporation, this double taxation is avoided because the profit of the corporation is passed through to the shareholder and only taxed at the individual level.

You only pay payroll taxes on your salary.

If you are actively involved in a partnership or the owner of a sole proprietorship, the company’s profit is all subject to self-employment taxes.  As the owner, you are responsible for both the employee and employer portion of payroll taxes which currently are 15.3%. 

In an s-corporation, you are required to pay yourself a reasonable salary.  The term reasonable salary is not defined by any IRS regulations, so this amount is open to interpretation and you should consult your accountant to discuss a reasonable salary for your business.

That being said, you only pay payroll taxes on the salary you pay yourself.  The remaining profit after paying yourself and all your other expenses is not subject to the payroll taxes which can yield significant tax savings.

S-corporations provide liability protection.

The s-corporate structure provides liability protection for the shareholders.  The shareholders’ assets are protected from the business creditors for claims rising from contracts or litigation.

Drawbacks of Forming an S-corporation

There is the initial setup cost and ongoing taxes.

There are several initial fees including the registration fees with the state and state taxes that the corporation is subject to.  If you operate in multiple states, you’ll need to review each state’s requirements and determine which states you need to register with. 

In California, s-corporations are subject to an annual $800 minimum tax although it may be  waived in the first year of operation depending on your profit.  There are annual Statement of Information filings required by the Secretary of State.  You should obtain local businesses licenses to ensure compliance with local regulations as well. 

Having a third-party filing your initial paperwork can cost thousands of dollars depending on which firm you use, but is often worth it to ensure that the paperwork is filed correctly and you have properly set up your corporation to receive the benefits listed above.

You are required to pay yourself a reasonable salary.

As noted above, you are required to pay yourself a reasonable salary. The reasonable salary can vary and should be discussed with your accountant.  However, the salary requirement requires you to have a payroll processing company or process the payroll yourself.  Payroll requires quarterly and annual filing (such as W-2s) and has stiff penalties for missing required payment dates. 

Your best bet is to use an online system to process payroll or work with a professional payroll processor, however the fees add up for either of these services.

You can only have one class of stock.

Distributions to shareholders must be made in proportion to the stock ownership.  So, if one personal owns 75% of the company, they must receive 75% of all distributions.  Distributing funds in a non-proportional manner creates a second class of stock which is not allowed under the s-corporation rules. 

Limitation on the number of shareholders.

Though this is not a problem for most small companies, the number of shareholders for an s-corporation is limited to 100.  In this case, married couples can be counted as single shareholder when calculating the limitation. 

You must use a calendar year.

Like the limitation on the number of shareholders this is usually not a problem for most people who are used to thinking about finances on an annual basis. An s-corporation is required to have a fiscal year that is the same as the calendar years ending on December 31.  C-corporations have the option of selecting a fiscal year end which may serve them better based on seasonal fluctuations in business. 

A woman stands on top of a hill with her arms outstretched, like you might if you just started an S-Corp!
It’s time to take on the world and start that S-Corporation at last!

How to Start an S-corporation

Register your corporation with your state.

Each state has their own policies and procedures when it comes to corporate formation.  The first step to establishing an S-corporation is to register as a corporation and then you file the s-election.

For California, you need to file your Articles of Incorporation with the Secretary of State (SoS).  You can create your own document for the filing as long as it meets the SoS guideline or you can use the form available only.  While the SoS required paper documents to be filed, it has recently changed its policy to allow online submission of the Articles.  Processing times still take a few weeks, so you need file weeks before you need to be up and running.

Register for an EIN.

Once your corporation hs been registered with your state, you need to head over to the IRS website and obtain an EIN.  The EIN (Employee Identification Number) is required for banking, paying employees, and filing your tax returns.  The IRS process for obtaining an EIN is relatively straightforward and you can obtain your EIN letter immediately online.  One item to note is that the IRS EIN website is only available during certain hours of the day and only on weekdays. 

You also do not want to get the EIN prior to receiving approval for your state corporate filing because it’s possible that the state will reject your corporate filing because of a name conflict in which case your EIN will have the wrong name associated with it.  You can fix an incorrect name, but it requires extra paperwork (and starting up a business takes enough paperwork, as is, so there’s not need to add more!)

File the S-election (Form 2553) with the IRS.

Form 2553 is an election to be taxed an S-corporation.  The form is straightforward and requires the business and owner’s information.  All owners of the corporation must sign the election.  If any owners are in a community property state (such as California) the spouse is also required to sign the election even if they are not listed as a shareholder.  The s-election needs to be filed within 2 months and 15 days of incorporation or the start of the tax year in which the corporation wants to make the election.  The IRS does allow late elections in some circumstances, but it’s always best to file timely paperwork.

While the submission process is easy, wait times for approval can vary.  It can take 2-3 months for the election to be approved and you to receive your approval letter.

Set up payroll services if they’re not already in place.

With the s-election’s tax savings comes the requirement for paying yourself a reasonable salary as discussed above.  To ensure that you’re following these rules, you should establish a payroll service for yourself if you don’t already have payroll set up through a processing company or online system.  There is no rules about when the payroll needs to be paid during the year, so you have until the end of the year to get this set up, but you don’t want to be scrabbling at the end of the year.


Have more questions about S-Corps, or anything else about business or accounting for that matter? Reach out to us at My OC Bookkeeper. We provide bookkeeping, accounting, and business advisory services to businesses all over Southern California. Want to learn more about starting a business in CA in general? This post will teach you everything you need to know about starting a new business in CA, or if you are a visual learner take a look at the video below.

One final great resource: check out the CA Secretary of State website to learn directly from the source. Always good to supplement your learning by spending a few minutes with the CA SOS.