Exactly what is an S corporation and what types of businesses may be interested in being an S Corp? First, it is very important to understand that an S Corp is a FEDERAL TAX STATUS of a corporation and not a type of entity. What does this mean? This means that when you form a corporation in Maryland (or any other state), you do not form an S Corp per se. In Maryland, you will form a regular corporation and then file an S Corp election with the IRS. (The Articles of Incorporation and/or the Organizational Meeting minutes will state that the corporation's owners will elect S Corp status.)
So, why would my corporation choose to be an S Corp? Under IRS regulations, because a corporation is a separate legal entity, it must usually file a tax return and pay taxes on its taxable income. However, the IRS regulations allow certain small businesses to be treated for tax purposes as if they were being run by the owners themselves without a separate entity. Under Subchapter S of the IRS regulations (this subchapter is where the name "S Corp" comes from), a corporation can elect to have the IRS disregard the corporation as a separate taxable entity and allow the taxable income or losses of the business to be reported on ("flow to" or "pass through" to) the owner of the business in proportion to their ownership shares. This prevents "double taxation" of corporate income because the income is taxed only at the owner level rather than at the corporate level as income and then again at the owner level as dividends.
Aside from the avoidance of double taxation, an S corporation offers flexibility regarding
how earnings are paid to its owners, whether they are paid as salaries (subject to FICA and other taxes) or as distributions, not subject to these taxes. An S corporation must file a tax return but the shareholders, not the S corporation, pay taxes on profits on their individual tax returns.
The I.R.S. has very specific criteria that must be met before an S corporation election is
approved. To be eligible a corporation must:
- timely file Federal Form 2553;
- have no more than 100 shareholders, who meet the specified I.R.S. definition of "shareholder;"
- have no nonresident alien shareholders; and
- have only one class of stock.
- and not be an "ineligible corporation" under the I.R.S. Code.
The following links provide more information on the required form and criteria in order
to be a qualified S corporation: https://www.irs.gov/pub/irs-pdf/f2553.pdf.
Before attempting to file these forms, however, you first must incorporate in
Maryland and file the required documents with Maryland's State Department of Assessment
and Taxation ("SDAT"), found at http://dat.maryland.gov/businesses/Pages/Maryland-Checklist-for-New-Businesses.aspx. Maryland requires that any corporation provide the following information: name of corporation, purpose for which the corporation is formed, the addresses of the principal place of business and resident agent, the issuance of stock shares and the par value, the number of directors pursuant to the bylaws (which can be increased or decreased), and the name of the directors and successors who shall act until the first meeting or until their successors are chosen.
Once the corporation is filed, the next step is to file an I.R.S. Form 2553 to elect S corporation status. After both of these steps, if all criteria has been met, an S corporation is valid.
Once the S corporation is formed there are legal requirements going forward. The most important requirements relate to the number of shareholders and the type of person or entity that can be a shareholder. S Corps are also limited to certain classes of stock they can issue. For this and other reasons, many tech startups planning to look to venture capital investment should not elect S Corp status.
Since there are many considerations in evaluating what type of business entity is best for your business, and once you decide that, how to go about meeting the requirements for both setting up and then maintaining your business, an attorney can be one of you most valuable assets.