Are you considering forming an S Corporation to avoid double taxation and pass profits?
If yes, you need to meet a few IRS requirements before you can enjoy these benefits. These rules help ensure that only the right types of businesses can elect S Corporation status. This makes it easier for you to manage taxes and stay in line with federal regulations. In fact, there are leading S Corp setup services that can help guide you through this process. They help ensure that everything is filed correctly and on time.
Let’s take a closer look at the main IRS requirements for forming an S Corporation.
1. Be a Domestic Corporation
An S Corporation must be a domestic (U.S.) corporation.
A domestic corporation is a corporation that is incorporated in the United States rather than in a foreign country. This includes any corporation formed under the laws of:
- Any U.S. state (like Delaware, California, or Texas)
- The District of Columbia
- U.S. territory such as Puerto Rico or Guam
2. Have Only Allowed Shareholders
The shareholders of an S corporation must meet certain requirements. They can include:
- Individuals: Only U.S. citizens or U.S. residents can be shareholders.
- Certain Trusts: Some types of trusts can hold shares in an S corporation, such as grantor trusts, voting trusts, and some types of qualified retirement plans.
- Estates: Estates of deceased shareholders can hold shares. There are limits to how long the estate can hold those shares.
However, the following entities cannot be shareholders in an S corporation:
- Partnerships
- Corporations
- Non-resident alien individuals (individuals who are not U.S. citizens or residents)
3. Limit of 100 Shareholders
An S corporation is limited to having a maximum of 100 shareholders. This limit is designed to keep the S Corp small and manageable. Family members can be treated as a single shareholder for the purposes of meeting the limit. If multiple members of a family own shares, they may be considered one shareholder as long as they are direct descendants or ancestors.
4. Have Only One Class of Stock
You can only have one class of stock. It means that all your outstanding shares must provide shareholders with equal rights to distributions and liquidation proceeds. Voting rights differences do not affect this rule. A second class of stock is created if you:
- Pay one shareholder their distribution earlier than others, or
- Give someone a larger amount than their percentage
Tip: Review your agreements and actual distributions every year.
5. Not Be an Ineligible Corporation
Here are the types of businesses that are excluded:
- Financial Institutions, including banks and thrifts (savings and loan associations)
- Domestic international sales corporations (DISCs) and insurance companies
These exclusions are designed to prevent S corporations from exploiting tax laws.
How To Elect S Corporation Status
The next step after meeting the IRS requirements is to elect S Corporation status. Here the step-by-step process:
Step 1: Submit Form 2553
File Form 2553 with the IRS in order to become an S corporation. The form must be completed and signed by all shareholders. It includes info about your business and the consent of each shareholder to elect S Corporation status. The election must generally be filed within 2 months and 15 days after the beginning of the tax year. For example, a business must file Form 2553 by March 15 of the year to begin S corporation status on January 1. If you miss the deadline, the IRS may provide relief for a late election if the corporation can demonstrate a valid reason for the delay.
Step 2: IRS Approval
The IRS will review the application after filing Form 2553. The business will be granted S Corporation status if the IRS accepts the form and determines that the business meets all the requirements.
| NOTE: The IRS does not send a confirmation notice for an S Corporation election unless there is an issue with the application. Keep a copy of Form 2553 and the IRS acknowledgement letter. |
Step 3: Ongoing Compliance
When your business becomes a S Corporation, it must meet certain ongoing compliance requirements, including:
- Filing annual tax returns
- Keep track of shareholder distributions
- Adhere to employment tax rules
Tax Filing
S Corporations must file Form 1120-S, U.S. Income Tax Return for an S Corporation, annually. This form reports the income, deductions, gains, and losses of the business.
Employment Taxes
If your S Corporation has employees, including shareholder-employees, the business must comply with all federal employment tax requirements. The requirements are:
- Social Security
- Medicare
- Unemployment taxes
These are reported on forms like Form 941 (Quarterly Federal Tax Return) and Form 940 (Annual Federal Unemployment Tax Return).
Conclusion
An S Corporation is an excellent way for business owners to reduce self-employment taxes, avoid double taxation, and earn more hard-earned profits. Leap with the leading S Corp setup services that can guide you through every step of the process. You can get the tools and support you need to get your business up and running efficiently.
