The short answer is, it depends upon what you mean by S-Corp.

Sometimes the term “S-Corp” is used to refer to a tax designation provided by the Internal Revenue Service, but sometimes the term “S-Corp” is used to refer to a specific type of entity.

This article aims to shed light on the common question: “Is an S-Corp an LLC?” It will provide a clear and concise explanation, breaking down the distinctions between an S-Corp, as a tax designation and entity type, and an LLC, or Limited Liability Company.

The goal is to enable businesses and entrepreneurs to make knowledgeable decisions when choosing their company structure.

Sometimes S-Corp Refers to a Tax Designation

Sometimes the term “S-Corp” refers to a tax designation provided by the Internal Revenue Service.

When the term “S-Corp” is used to refer to a tax designation, it is specifically referring to Subchapter S of the Internal Revenue Code.

This is a unique tax designation granted by the IRS that allows certain business structures to pass income, losses, deductions, and credits through to the personal tax returns of their owners for federal tax purposes.

How Taxation as an S Corporation Works

IRS Form 1120S

Under S Corporation taxes, the business structure electing this tax classification itself is not taxed. Instead, the business structure with an S Corporation tax classification files an informational income tax return on IRS Form 1120S, but the profits and losses of the business are passed through to the owners on Schedule K-1.

Schedule K-1

Each owner takes their Schedule K-1 from the IRS Form 1120S tax return and declares the business income of the business structure with an S Corporation tax classification on Internal Revenue Service Form 1040, their personal income tax return, along with any other sources of income they must declare from W-2s, 1099s, K-1s from other businesses they might own, along with any other sources of taxable personal or business income they must declare.

Tax Benefits of S Corporation for Income Taxation

There are several tax benefits associated with choosing S Corporation taxation, making it appealing to many small business owners.

Pass-Through Taxation of S Corporations

One of the primary tax benefits of S Corporation taxation is the pass-through taxation feature. This feature allows small business owners of businesses with S-Corp status to report their share of company profits and losses on their personal tax returns at personal tax rates, thereby avoiding the double taxation that is commonly associated with a C Corp.

Double Taxation of C Corporations

Standard corporate income tax, often referred to as C Corporation or C corp taxation, is the default tax classification for corporations under the Internal Revenue Code. Unlike S Corporations, which pass through profits and losses to the personal tax returns of owners, a C Corp will pay federal taxes on income at the entity level. This means that the corporation pays federal taxes on its net income, which is the profit after subtracting allowable deductions from its gross income.

After a C Corp pays corporate taxes income tax at the corporate structure level, the C Corp may share its post-tax earnings with its owners in the form of dividends.

These dividends are considered taxable personal income for the business owner. Dividends are generally taxed at the federal income tax rates for qualified dividends, which are currently lower than the ordinary income tax rates. As of 2021, the tax rates on qualified dividends are 0%, 15%, or 20%, depending on the taxable income and filing status of the business owner.

This entity-level taxation followed by dividend taxation gives rise to what is commonly referred to as “double taxation” of business income.

Tax Benefits of S Corporation for Self-Employment Tax

Another key benefit is the ability to potentially save on self-employment tax.

Income Tax for Sole Proprietorships and Single-Member LLCs

A Single-Member Limited Liability Company, by default, is a disregarded entity for income tax purposes. This means the Internal Revenue Service treats the LLC owner as a sole proprietorship. The income, expenses, and credits of a sole proprietorship or Single-Member LLC are reported directly on the personal income tax return of the LLC owner using Schedule C of Internal Revenue Service Form 1040. While the mechanics are different, this essentially causes sole proprietors and sole owners of LLCs to be taxed as if they were pass-through entities.

Income Tax Under Partnership Taxation

General Partnerships, Limited Partnerships, Limited Liability Partnerships, or Limited Liability Companies with multiple owners, by default, are treated as a partnership for federal tax purposes, and thus are also pass-through entities. Partnership taxation follows a system similar to the S Corporation in the sense that it does not pay federal taxes at the entity level, but uses pass-through taxation avoiding double taxation and passing liability for taxation of company profits to the business owners. Under partnership taxation, business structures file an informational return on Internal Revenue Service Form 1065 and each owner receives a Schedule K-1, just like S Corporations, so the owners may pay federal taxes on the business income similar to S-Corp status.

Self-Employment Tax and Sole Proprietorships, Single-Member LLCs, Partnerships, and Multi-Member LLCs Taxed as Partnerships

Sole Proprietors, LLC owners, and partners in partnerships who actively participate in the management structure of such a business structure pay self-employment taxes on all of their share of the business income up to the statutory maximum.

Self-employment taxes refer to the employer portion and employee portion of Social Security and Medicare taxes. For the tax year 2021, the self-employment tax rate is 15.3%, which consists of 12.4% for Social Security and 2.9% for Medicare.

Self-employment taxes are applied to the net earnings of the business, which is the profit after subtracting business expenses from business income, but do not act as a business expense deductible for purposes of business income taxation.

No Self-Employment Taxes to in an S Corporation or C Corp Business Structure

Unlike Sole Proprietors, LLC owners, and partners in partnerships, the owners of S Corporations and C Corporations are not subject to self-employment taxes.

Employment Taxes in an S Corporation or C Corp

Owners of a business entity taxed as an S Corporation or C Corp receive income in the form of salaries, dividends, and distributions, which are exempt from self-employment taxation, which provides significant tax advantages to both the S Corporation and C Corp.

Although the salaries are subject to payroll taxes including Social Security and Medicare taxes, the dividends and distributions are taxed without any form of payroll taxes or employment taxes.

This approach potentially provides significant tax savings, however, the Internal Revenue Service requires that an owner receiving income from an S Corporation or C Corp must receive a “reasonable salary” before receiving dividends or other distributions, and this salary is subject to employment taxes. The definition of a “reasonable salary” varies, but it’s generally considered to be what similar businesses pay for similar services provided by a non.

Sometimes S-Corp Refers to a Specific Type of Business Entity

In certain instances, the term “S-Corp” is not merely a reference to a tax designation, but is used to denote a specific type of business entity.

While not an official business structure like a Limited Liability Company or a corporation, the term S-Corp is used to describe a corporation that the shareholders elect to be taxed under Subchapter S of the Internal Revenue Code after formation. Therefore, when we talk about an S-Corp as a business entity, we are referring to a corporation that has chosen to be taxed as an S Corporation.

As discussed above, choosing to form an S-Corp allows companies to avoid the double taxation of a C Corporation while also enjoying all the benefits of a corporation, including limited liability protection.

How to Form an S-Corp

Requirements to form an S-Corp vary from state to state, so it is always advisable to engage an experienced corporate attorney who is familiar with the specific laws and regulations of the state in which the S-Corp will be formed to guide you through the formation process.

While the specifics may differ, a general overview of the process is outlined in the following subsections.

Form a Corporation First to Form an S-Corp

Before you can elect S-Corp status, you must first create a corporation having only one class of stock.

This involves choosing a business name that is unique and compliant with the state corporation laws of your choosing and filing Articles of Incorporation or a Certificate of Incorporation compliant with the corporation laws of that state with the Secretary of State or other governmental agency that handles such filings.

Filing fees and processing times will also vary from state to state.

Create Corporate Bylaws for an S-Corp

Corporate bylaws are essential internal documents that outline the operational guidelines and regulations for your corporation.

These bylaws serve as a comprehensive framework for defining the structure, governance, and decision-making processes within your S-Corp. While not required to be submitted to the state, they play a crucial role in ensuring the smooth functioning and legal compliance of your S-Corp. With detailed provisions on matters such as shareholder rights, responsibilities of the board of directors, and voting procedures, bylaws provide a solid foundation for effective corporate management and decision-making.

In conclusion, drafting a comprehensive set of corporate bylaws is a critical step in forming an S-Corp, as it offers a legal framework for corporate governance, enhancing the efficacy of decision-making processes and ensuring conformity with state laws.

Appoint an S-Corp Board of Directors

To ensure effective governance of the corporation, owners must carefully select a board of directors.

The role of the board of directors is to diligently oversee and manage the affairs of the S-Corp. These highly qualified individuals, as stipulated in the corporate bylaws, will collectively bring their expertise and experience to guide strategic decision-making and foster the long-term success of the organization.

Notwithstanding the foregoing, most of the time a small business corporation will appoint its shareholders to its board of directors.

The appointment of the board of directors is a pivotal step in forming an S-Corp, ensuring that the company is driven by collective expertise, sound strategic decision-making, and adherence to legal requirements.

Hold the First Board of Directors Meeting of an S-Corp

At the first board meeting, directors typically gather to discuss and make important decisions that shape the foundation of the S-Corp.

Among these decisions, they commonly approve the corporate bylaws, which serve as a set of rules and guidelines for the governance and operations of the S-Corp. Additionally, the board of directors sets the fiscal year, determining the start and end dates for financial reporting and planning purposes.

To ensure smooth functioning and accountability, corporate officers are appointed during this meeting, assigning key roles and responsibilities within the leadership structure of the S-Corp. Just as the board of directors for a small S-Corp are usually the future shareholders, in a small business corporation the officers selected to fill the key roles are often those same shareholders and members of the board of directors.

Written minutes of the meeting, capturing the discussions, decisions, and actions taken by the board should be created and stored in the corporate records book of the S-Corp, serving as a valuable reference for future deliberations and legal compliance.

The first meeting of the board of directors sets a vital precedent for the S-Corp, establishing its governance structure, approving its bylaws, and paving the way for effective and accountable corporate operations.

Issue Shares of Stock to S-Corp Founders

Once the foundational structure of the S-Corp is established, the next step is to issue stock to the founders.

Determining the Number of S-Corp Authorized Shares

The process of issuing shares of stock to S-Corp founders begins with a determination of the total number of shares the corporation will authorize. This number, which must be specified in the Articles of Incorporation, Certificate of Incorporation, or other founding document, essentially represents the maximum number of shares the corporation can issue.

Determining the Number of S-Corp Shares to Issue to Founders

While not all authorized shares need to be issued immediately, it is a good practice to issue all shares of a small business corporation to the founders to avoid potential problems with future issuances, and an S-Corp may always amend its Articles of Incorporation, Certificate of Incorporation, or other founding document with the approval of its board of directors and shareholders in the future if needed. However, if an S-Corp is being formed with the knowledge that investors or persons other than the original founders will be joining the S-Corp as shareholders in the foreseeable future, the S-Corp can choose to retain some of the authorized shares for such future use.

Setting Investments of Personal Assets to the S-Corp

The board of directors of the S-Corp then must decide how many of these shares will be issued to the founders, but this should typically be discussed and agreed upon among the founders before the formation of the S-Corp. The precise number of shares issued to each founder is generally reflective of the investment of their personal assets, whether cash or non-cash, to the S-Corp.

When a founder makes a contribution of personal assets in the form of cash to an S-Corp, it is essentially an exchange of money for a specific number of shares of the stock in the S-Corp. This transaction denotes a monetary investment in the S-Corp, where the founder provides capital to the S-Corp and, in return, receives an ownership interest represented by the shares of stock.

On the other hand, non-cash contributions of personal assets, also known as in-kind contributions, may include contributions of tangible assets like equipment or property, or intangible assets such as intellectual property or services. In these instances, the contributor provides the S-Corp with the non-cash asset, and in return, receives shares of stock in the S-Corp, establishing an ownership interest.

Regardless of the nature of the contributions of personal assets being cash or non-cash, it is crucial to understand that Subchapter S of the Internal Revenue Code necessitates equity in the issuance of shares. This means that the same contribution must be made for each share of stock issued at the same time, and failing to adhere can cause S Corporations to lose their status as S-Corps and be subject to the standard double taxation of a corporation.

Federal and Blue Sky Securities Filings for S-Corps

Federal and Blue Sky securities filings are frequently necessary when issuing shares of stock to S-Corp founders.

These are regulatory filings required by both federal securities laws and state securities laws, termed “Blue Sky Laws”, designed to protect investors from fraudulent investment schemes.

Comprehension and adherence to these laws and regulations is paramount to prevent any legal complications or regulatory penalties.

Issuing Stock Certificates for an S-Corp

Once the personal assets have changed hands and all federal and blue sky securities laws, regulations, and filings have been completed, the S-Corp may record the issuance in the stock ledger for the S-Corp and issue stock certificates to the founders, which documents their ownership in the S-Corp.

Issuing stock to founders is more than just a formality; it is a legal process that affirms ownership and voting rights in the S-Corp. Therefore, it is advisable to seek legal counsel to help guide you through this process and ensure regulatory compliance.

Obtain an Employer Identification Number for an S-Corp

An Employer Identification Number, which acts sort of like a social security number for the S-Corp and is required for both tax and banking, must be obtained from the Internal Revenue Service.

Obtaining an Employer Identification Number for an S-Corp is a straightforward process, which may be completed via the website of the Internal Revenue Service, which will guide you through the questions, or by submitting a completed Internal Revenue Service Form SS-4 by fax or mail.

S Corporation Election on Internal Revenue Service Form 2553

So far, all the previous steps are the same steps used to form a C Corporation, but the final step is where the C Corp finally becomes an S-Corp.

In order to obtain S Corporation status, all S-Corps must complete and submit Internal Revenue Service Form 2553 no more than two months and 15 days after either the date of formation of the corporation or the beginning of the tax year the election is to take effect.

One of the most common issues we see for clients who try to form S-Corps with the use of online or other non-attorney service providers is the failure to timely file for S Corporation status because all shareholders of S-Corps and their spouses must sign the application along with an authorized signatory of the corporation before it can be submitted, so always consult with an experienced corporate attorney to ensure this application is completed correctly and filed timely.

When is an LLC Also an S-Corp?

It is possible to form an LLC that can also be considered an S-Corp for taxation purposes.

An LLC in itself is a separate legal entity, providing its owners, known as members, liability protection akin to that enjoyed by shareholders of a corporation. However, the IRS does not consider an LLC to be a separate tax entity, and therefore, it allows LLCs to elect how they are classified for taxation purposes. Consequently, an LLC can opt to be taxed as an S-Corp.

This unique setup combines the flexibility and simplicity of an LLC with the advantageous self-employment tax savings of an S-Corp, making it an attractive option for many business owners. This is a nuanced process, so understand the tax obligations and the relevant procedures before making such an election.

Clarifying the Nomenclature Between S-Corps and LLCs

While an LLC may elect to be taxed as S Corporations, it is important to clarify how the terms are commonly used. in the industry.

The term S-Corp is generally understood to refer to a corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code.

When LLCs choose this taxation structure, they are most accurately described as LLCs taxed as S Corporations.

This distinction is crucial for clear communication and understanding in legal and business contexts.

Form an S-Corp or Elect an LLC to be Taxed as an S-Corp Today!

Ready to form an S-Corp or an LLC to be taxed as an S-Corp? Don’t navigate the complex legal landscape alone. Partner with the experienced attorneys at San Diego Corporate Law today. We are here to guide you through each step, ensuring your business is positioned for success. Contact us today and let us help you get started on building the future of your business.