Forming an S Corporation

The following article is very informative, it was written by Colleen Debaise, adapted from "The Wall Street Journal Complete Small Business Guidebook" (Three Rivers Press).

Some business owners prefer to set up an S corporation, which provides liability protection while allowing profits to pass through to the owners' personal tax returns. This special tax status (its letter refers to subchapter S of the Internal Revenue Code) prevents the double taxation scenario created under a C corporation.

Owners of S corporations can reduce their overall tax bill by paying themselves a salary, subject to payroll taxes (Social Security and Medicare taxes), and then taking a dividend, which is distributed free of employment taxes (and, again, isn't subject to the corporate tax rate). There's a catch, though: that salary must be reasonable, which can be determined by researching salaries in similar industries in the same geographic region. The IRS is well aware that many owners of S corporations are tempted to underreport salary to avoid paying payroll taxes, while taking a hefty payroll-tax-free dividend. To avoid trouble with the IRS, set your salary at a reasonable level based on salaries for comparable positions— and keep careful records in the event of an IRS audit.

To set up an S corporation, you follow the same steps for setting up a regular corporation but take the extra step of electing S status via a special IRS form. To qualify for S corporation status, you must meet certain rules, such as having fewer than one hundred shareholders and issuing only one class of stock (preferred shares aren't allowed).