Despite a sharp decline in small business activity early on during the pandemic, the industry has experienced a significant resurgence since then. In fact, American Business Formation Statistics (BFS) have demonstrated there has been a surge in new business applications. Small businesses compose the biggest part of the American economy, and the two most common business structures for small businesses are LLCs and corporations.
Limited liability companies (LLCs) and corporations are permitted by the Internal Revenue Service (IRS) to opt to shift from their standard tax designation to an alternative one known as an S corporation (S corp). This article will explore what this tax designation means for a company that elects it, before detailing how you can form one and whether you should.
What Is An S Corp?
S corps are not a business structure that prospective entrepreneurs can form their business as. Rather, they are a specific tax delegation created by the IRS that LLCs and corporations can elect to be recognised as. For certain companies in specific situations, it is financially optimal to be taxed in this way.
It is becoming an increasingly popular inclination for business owners to elect to be taxed as an S corp. The primary benefit of doing so is that it enables the company to be recognised as a ‘passthrough entity’; the effect of this is that the profits of the company remain untouched by corporation tax, and instead ‘pass through’ straight to owners, whose salaries, which have come out of these profits, are subject to personal income tax.
The primary difference between this and an LLC, which is also recognised as a ‘passthrough entity’, is the acknowledgement of owners with an active role in an S corp as employees, who thus must be paid an ‘adequate salary’ based on the market rate of the services they provide. By contrast, LLC owners pay themselves with owner’s draws.
The benefit of acknowledging owners as employees in an LLC is that they are no longer liable to pay self-employment taxes, which can save them thousands
How To Form An S Corp
Since it is only really recommended to form an S corp as an LLC, since doing so as a corporation negates all of this tax delegation’s benefits, the process of forming an S corp is as simple as registering an LLC before notifying the IRS by filing Form 2553.
Choose An LLC Name
The first step in the formation of an LLC involves choosing a name that is not in use by any other company in the state, but is also in agreement with all of the chosen state’s requirements for the naming of a business.
Elect An RA
All businesses are required to elect a registered agent (RA), which can be either an individual or a company. This party handles all the important correspondence in the name of a business, including communication with the State as well as legal summons etc. A business’s RA is also expected to file its articles of organization during its formation process.
Submit Articles of Organization
Speaking of the articles of organization, this document is the final form to be submitted in order to formally enter a business into the state.
Produce An Operating Agreement
Whilst not a legal requirement, it is always recommended that a business complete an operating agreement as it can prevent many major conflicts between members down the line. It ensures that all key players are on the same page right off the bat by agreeing on the company’s ownership and member duties from the beginning.
Complete IRS Forms
The final step in the formation of an S corp is to complete an EIN application on the IRS’s website. From here, a direct link is provided to Form 2553 – this confirms a small business’s choice to be recognised as an S corp.
Evidently, electing to be treated as an S corp by the IRS can be extremely beneficial for companies in specific circumstances: it enables owners to be treated as employees of the company, thus precluding them from paying self-employment taxes. This is only the case however, if this tax delegation is used appropriately.
For more information on when this situation arises, as well as an s corp definition, feel free to visit The Really Useful Information Company’s (TRUiC) article on the subject.
via: Information Nigeria