How to Start an S Corp: Everything You Need to Know

There’s a lot to learn as a business owner, and one thing many new and small business owners are curious about is how to start an S corp. An S corp isn’t exactly a type of business -- it’s a tax filing status that can offer you serious benefits, especially tax savings and legal protections.

This is appealing stuff for business owners, but here are a few things you need to know before you start filling out paperwork. You need to learn exactly what an S corp is, benefits and drawbacks, how to qualify for S corp status, and the steps to setting up an S corp. This quick guide covers it all.

How to start an S Corp & everything else you need to know

What is an S corp?

S corp or S corporation is an IRS tax status that allows businesses to pass corporate income, losses, deductions, and credit through shareholders for tax purposes. This is why S corps are referred to as pass-through entities.

Businesses owners still file taxes, but they avoid “double taxation” with S corp status, which is when business income is taxed at the corporate rate and again on individual tax returns. Basically, electing for S corp status can bring on some serious tax savings for a business, and that’s why S corps are the most common type of corporation. 

Benefits of an S corporation

There’s one really obvious benefit to learning how to start an S corp -- potential tax savings. And as a business owner, I definitely get it, but that’s not all

Tax perks

S corps are considered pass-through entities which means you avoid double taxation. You do file taxes for your business, but you’re filing your business and personal taxes together and not paying corporate taxes.

The pass-through aspect of S corps means that after you’re compensated, any profits are passed through to the business and divided among shareholders. The tax rate on profits is lower than regular income. 

Additionally, if your business experiences losses for the year, you can write them off on your taxe to offset other income. Exact rules on this vary state to state, so check with a tax professional or research the rules in where your business is located.

Liability protection

S corporations protect business owners by separating their business assets from their personal assets. If you were sued or had significant business losses, your S corp filing status shields your personal finances.

Compensation and dividends

If you’re a shareholder and an employee, you’ll be paid your salary plus profit-sharing earnings. This can be another tax perk because dividends are taxed at a lower rate than self-employment income.

Related: How to Handle Taxes for Your Side Hustle

Drawbacks of an S corporation

For as good as S corps are, there are a couple of downsides you should be aware of. Many business owners still find it worth learning how to start an S corp because the benefits outweigh the drawbacks.

More complex operating rules

Part of setting up an S corp is drawing up bylaws that dictate how your business operates, and there are a few things all S corps must include. For example, you must hold regular shareholder meetings that involve taking minutes. In general, S corps are required to have strict operating structures.

The IRS is paying close attention

Because of the tax benefits, the IRS is known for keeping a closer eye on S corps. That mainly means you have to adhere to their exact requirements, otherwise you can have your S corp status revoked.

How to quality for S corp status

There are several qualifications your business needs to meet to get S corporation status. These are essential requirements put in place by the government, and it’s worth checking this list to make sure you qualify.

• Be a domestic corporation. This is a company formed and operated in the U.S.
• Have only allowable shareholders. Shareholders can be individuals, certain types of trusts and estate. Shareholders may not be partnerships, corporations, or non-resident aliens.
• Have no more than 100 shareholders. All of your shareholders must consent to their election.
• Have only one class of stock. S corps may not have multiple types of stock types, such as voting and non-voting shares.
• Not be an ineligible corporation. Some kinds of financial institutions, insurance companies, and domestic international sales corporations are ineligible for s corp status.

If your business hasn’t adopted a tax year, you’ll also have to do that set up an s corp. You can adopt a tax year ending on December 31, a natural business year, a tax year listed under Section 444 of the Internal Revenue Code, a 52 or 53-week tax year, or any other tax year that the corporation has established for business purposes (much confirm using IRS Form 2533).

How to start an S corp in 6 steps

1. Register your business

S corporations must start as another business type before they can be set up as an s corp. You’ll do the state your business is located in, and each state has its own requirements for setting up a business. You can set up your business as an LLC or a C corporation -- these are the most common two types for starter businesses.

The registration process requires that you:

• Have a business name, and a doing business as name in some cases
• Register with the IRS so you have a EIN
• Register with local state agencies
• Apply for necessary licenses and permits (dependant on the type of business you run)

Again, every state has their own requirement, so check with your state’s agency to make sure you follow the correct steps.

2. Select your board of directors

S corps are required to have a board of directors, and they act on behalf of the shareholders to make overall policy decisions and provide oversight for the company. 

The members of your board can be a mix of insiders and outsiders, and they will be required to meet at regular times to discuss the corporation. 

3. Determine stock category

S corps are required to issue company stock, which can be common or preferred. Preferred stock gives no voting rights to shareholders while common does. And preferred shareholders are paid dividends before common shareholders.

You’ll want to pick the stock category that makes the most sense for your business. 

4. Draft articles of incorporation

Articles of incorporation are required to set up an s corp, and you’ll file these documents with whatever state agency regulates businesses (often the Secretary of State) and the IRS. This document should include:

• Name of your business
• Name and address of your corporation’s registered agency (aka the person who the state will contact regarding any legal issues)
• What type of corporate structure you are
• Names and addresses of all members of your board
• Type and amount of authorized shares
• Duration of the business, listed as perpetual if it’s ongoing
• Name, signature, and address of the incorporator

5. Draft bylaws for your S corp

If your business was initially set up as a C corporation, then you’ll already have bylaws in place. If not, then you’ll need to put together your bylaws, which is a document that explains how your business is structured and how it operates.

Bylaws are different from articles of incorporation, and must explain how to elect and remove directors, how to sell shares, information on holding meetings, voting rights, and what happens when a director or officer dies.

6. File IRS Form 2553

IRS Form 2553 is the official document to file when you’re ready to elect S corp status. It gets filed with the IRS, and they may be a similar form to file with your state. 

There are timeline restrictions for filing IRS Form 2553. It must be filed:

• No later than two months and 15 days after the selected tax year begins
• Any time during the tax year before the tax year that S corp status will take effect

You may be approved for a late election if you can show a reasonable cause for failing to file on time, and you should hear back within 60-90 days (depending on your tax year request) within filing about whether or not your application was accepted.

As soon as your S corp status is accepted, your business will have S corporation tax status.

How to file S corp taxes

One of the perks of learning how to start an S corp for your business is that you’ll enjoy pass-through taxation. That means S corporations don’t pay corporate income tax, instead the company’s owners pay taxes on their portion of the company’s earnings.

Pass-through taxation does not mean your business doesn’t pay taxes, though. Here’s how to file S corp taxes:

1. Prepare your financial statements. Your tax professional will ask for your profit and loss statement, your balance sheet, and any other documentation of your business taxes. You’ll also need these documents if you want to file your S corp taxes yourself with tax software.
2. Issue Forms W-2. W-2 compensation is a business deduction, but before you can do anything with that, you must issue a W-2 to all employees of your S corp. Shareholders who hold managerial positions should also receive a W-2. 
3. Prepare Form 1120-S. S corporations file business returns called information returns, and you’ll do that using Form 1120-S. This is a slightly more confusing version of Form 1120, which is used by C corporations. This is where you’ll deduct compensation paid to W-2 employees and shareholders, 
4. Distribute Schedule K and K-1. These are two separate forms and both need to be filled out. Schedule K is started on Form 1120-S and it summarizes your business’s income, deductions, and credits passed along to shareholders. K-1 tells shareholders the portion of S corporation earnings that they are responsible for paying taxes on.
5. File Form 1040. S corp shareholders pay taxes on their salary and their portion of S corp earnings. W-2 income from your S corporation goes on line one of Form 1040, and your share of the earnings is entered on part two of Form 1040 Schedule E.

It’s never a bad idea to get a professional involved when you’re filing your S corp taxes. The kind of filing status you get from learning how to set up an S corp helps you save money, but the paperwork that goes along with taxes is more confusing than other types of business structures.

The final word on how to start an S corp

Setting up an S corp can offer serious benefits to many types of businesses. The tax savings alone can be significant, but so is the liability protection this filing status offers.

If it’s right for you, make sure you follow the steps to correctly set up your S corp. You’ll want to stay on top of record keeping and stay accountable to your shareholders.