What is an S Corporation?

An S Corporation is a type of corporation created through an IRS tax election. Specifically, it is a corporation that is designated Subchapter S by the IRS. They are closely held corporations that make an election to be taxed under Subchapter S of the Internal Revenue Code. Similar to an LLC, the owner(s) of an S Corporation are given limited liability and pass-through taxation. What this means is that the business itself is not taxed. Only the shareholders (i.e., owners) are taxed. The income and losses are passed to the shareholders of the S Corporation, who then report income or loss on their personal income tax returns. However, there is one major point of emphasis – any shareholder who works for the corporation must pay himself/herself “reasonable compensation” (i.e., salary).

How to Form an Ohio S Corporation

Forming an S Corporation in Ohio begins by going to the Ohio Secretary of State’s website and conducting a business name search. This will allow you to ascertain whether the name you wish to call your business is available. When considering a name be aware that business names must be “distinguishable upon the records in the office of the Secretary of State” from other business names that are already registered. For example, “Johnson and Johnson” is not distinguishable from “Johnson & Johnson.” If your business name is available, go ahead and claim it.

Once you have decided on a name and it is available, the next step is to complete form 532A “Initial Articles of Incorporation” with the Ohio Secretary of State’s office. The filing fee is $125 and allows for the issuance of 1500 shares of stock. The corporation’s “Articles” must include a corporate name and be distinguishable from the name of any domestic or foreign business entity. Additionally, the “Articles” must contain the corporation’s principal office, the authorized number of shares of stock, their classification and par value, initial stated capital (if any) and appointment of a statutory agent.

Once Ohio has approved your corporation, all shareholders must file IRS Form 2553 to elect to have your corporation be taxed as an S corporation. Once approved, contact the IRS and obtain an EIN (employer identification number). This is required, even if you do not envision having employees, because banks will not allow you to open a business bank account unless you have an EIN. You must also contact several Ohio agencies, including: Ohio Department of Taxation, Ohio New Hire Reporting Center, Ohio Bureau of Worker’s Compensation, and Ohio Department of Jobs and Family Services. Finally, consult the Ohio Business Gateway to obtain the necessary licenses and permits.

After satisfying the necessary requirements outlined above, hire employees for your business and consult an attorney regarding the creation of several types of agreements, including a buy-sell, non-compete and confidentiality agreement.

Do I Really Need a Buy-Sell, Non-Compete and Confidentiality Agreement?

Although the State of Ohio does not require these agreements, you should not start a business without them. A buy-sell agreement stipulates what will occur if an owner or shareholder decides to leave the business, dies or wishes to sell his or her share of the business. In addition to covering these events, a buy-sell agreement can set forth how major business decisions are to be made and how the company is to be managed.

A non-compete agreement allows a business to decrease the possibility that an employee, who gains knowledge of business while in its employ, can that knowledge to the disadvantage of the employer. It can allow you, the business owner, to restrict the ability of that employee to work in a certain geographic area for a specified time. Confidentiality agreements are also advisable and work well in conjunction with non-compete agreements. Confidentiality agreements are binding contracts whereby a person or business agrees to treat certain information as a trade secret. Such agreements can protect a variety of types of information, such as proprietary information.

While a new business owner (specifically one without co-owners) may not feel that these agreements are needed at the beginning, they are items that must be thought about early on. Attempting to do a buy-sell agreement after a business has been up and running for several years can result in disagreements between co-owners on how to implement the agreement. Hiring employees and then asking them to sign a non-compete will most likely result in the agreement not being valid in court. Establishing a confidentiality agreement after employees have already left the business undermines the point of the agreement.

How an S Corporation is Taxed

S corporations are similar to LLCs in that they are pass-through entities that allow the owner(s) to report business profit and losses on their personal income tax return. The S corporation is not taxed as a separate entity. However, there are complications in electing to be taxed as an S corporation.

One of the best components of the is the potential tax savings from the business owner. Comparing it to an LLC, whose members are subject to self-employment tax (Social Security and Medicare) on the entire net income of the business, an S corporation owner/shareholder who is an employee of the business only has their wages taxed. The remaining income is paid to the owner as part of a “distribution,” which is taxed at a lower rate. The problem, however, is payment of a “reasonable” amount of compensation.

S corporations do not have to pay self-employment tax on their share of the business’ profits. However, before any profits are realized, each owner who also acts as an employee must be paid a “reasonable” amount of compensation (i.e., salary). This salary is subject to Social Security and Medicare taxes to be paid half by the employer and half by the employee. The potential for savings only kicks in once the S corporation is making enough money that there are still profits to be paid out after the business has paid the required “reasonable compensation.”

Let’s look at these rules in context. David owns an S corporation. His revenues from the business are $70,000 for the year and his annual business expenses are $10,000. Thus, the S corporation has profits for the year of $60,000. David wants to pay himself $45,000 in salary for the year and count the remaining $15,000 as profit. This would result in David not having to pay self-employment taxes on the $15,000 in profit. However, David knows that a reasonable salary for a professional in his area in the same line of business is $60,000. David could pay himself $45,000 in salary and $15,000 as a distribution of profits, but David does not want any issues with the IRS and would have a hard time arguing that $45,000 is reasonable compensation. Thus, to avoid this potential trouble, David should pay himself $60,000 as salary. Therefore, David did not receive any benefit from S corporation taxation.

This article should not be taken as legal advice and does not create an attorney-client relationship. For a detailed discussion on taxation, please contact a tax professional. If you wish to form an S corporation, call Johnson Legal, LLC at (614) 987-0192 and speak with attorney David Johnson.