When setting up and growing a business, you need to keep the legal structure and tax status of your business in mind. As your business grows, it could become necessary to reevaluate and change the tax status of your business so that you can benefit from certain tax advantages. An S Corporation (or S Corp) is one of the business entities that you might consider as your business expands. It could be the ideal choice for your small business, offering a number of financial benefits.
Table of Contents
- What is an S Corporation?
- Advantages and Disadvantages
- S Corp vs LLC and Corporation
- Requirements to Be an S Corporation
- How to Start an LLC with S Corporation Taxation
- Frequently Asked Questions (FAQs)
An S Corporation is a tax status that was designed for small and family businesses. Also called a subchapter s corporation, it eliminates double taxation by giving a corporation with 100 or fewer shareholders the benefit of incorporation while simultaneously being taxed as a partnership. It allows income to be passed to shareholders directly to remove double taxation, which happens with a standard corporation. There are several requirements that need to be met for S Corporation status, such as being a domestic corporation and having no more than 100 shareholders.
The S Corporation tax status is obtained by filing Form 2553.
Making your business an S Corporation can deliver both advantages and disadvantages to your company. Before deciding whether becoming an S Corporation is right for you, it’s important to understand all of the benefits and drawbacks that could affect you.
Benefits of S Corporation status
The key benefits that you can obtain from making your business an S Corporation include:
- Tax advantages
- Asset protection
- Establishing credibility
- Flexibility with characterizing income
- Easy ownership transfer
For many businesses, the tax advantages are a major benefit to filing under Subchapter S Corporation. S Corporations are not required to pay federal income tax, apart from on some capital gains and passive income. The business structure allows profits to pass to shareholders, which are then taxed through their person tax returns. This means that the corporation’s profits are only taxed once and double taxation is avoided.
An S Corporation is a separate tax status, which provides you an extra level of protection for your personal assets. When you are a shareholder of an S Corporation, you are not responsible for any of the corporation’s debts or liabilities. Your personal assets are safer and creditors can’t usually go after your personal assets if debts are not paid.
Registering as an S Corporation can offer the advantage of giving your business more credibility and respectability. Customers, investors, employees and suppliers may regard your business more highly if it is registered as an S Corporation, showing that it is firmly established as an official business.
Another financial benefit for an S Corporation is that it allows you to decide how to characterize your income. You have the option of being an employee of the S Corporation and paying yourself a salary. In addition to this, you can pay yourself dividends or distributions, which are either tax-free or taxed at a lower rate. Using these methods, you can further reduce your tax liability. An accountant can help you to make sure you do this in an appropriate way.
Finally, an S Corporation offers the advantage of easy ownership transfer. This can be carried out without incurring significant tax charges or the need to follow complicated accounting rules.
Disadvantages of an S Corporation
Registering as an S Corporation can have some disadvantages too and may not be for everyone.
The IRS takes care to be particularly thorough when assessing S Corporations. Reasonable salaries must be paid to shareholders who are also employees, and they don’t want to see that an S Corporation is unreasonably avoiding paying payroll taxes through paying dividends. If they catch anything that they don’t like, you may be asked to recharacterize income and pay higher taxes. If some mistakes aren’t rectified, the corporation could even be terminated in some circumstances.
Establishing your business as an S Corporation can take time, as well as money. It requires articles of incorporation to be submitted to the Secretary of State. A registered agent is needed for the business and there are incorporation fees too. You may be required to pay various annual fees, depending on the state.
There are some limitations too, with S Corporations only allowed to offer one class of stock and have no more than 100 shareholders. An S Corporation can’t be owned by foreign shareholders or some types of trusts or corporate entities.
To decide which tax code is right for your business, it’s also beneficial to understand the other types of business that are available. Apart from nonprofits, the two main types of business that you need to know about are LLCs and C Corporations.
Limited Liability Company (LLC)
An LLC (limited liability company) can be taxed as an S Corporation or sometimes a C Corporation. When a business is set up as an LLC, the owner pays tax on any profit and distributions. An LLC can also have an unlimited number of members, unlike an S Corp. For many small businesses, it makes more sense to file taxes as an LLC. This is because they may not have a large enough net profit to benefit from filing as an S Corp. However, some small business owners find that as their business grows, the tax benefits of becoming an S Corporation can help them to save a significant amount of money.
A C Corporation is not limited to having only 100 shareholders, unlike an S Corporation and can have more than one class of stock. C Corporations are subject to being directly taxed and must pay corporate income tax. Once corporate tax has been paid the board of directors of a Corporation can choose how much of their remaining profits will be retained earnings and how much will be distributed to shareholders as dividends. If dividends are paid out, shareholders are subject to taxation on that income. Like an S Corporation, filing a separate tax return for the corporation is required.
There are several requirements that need to be met in order to file as an S Corporation:
- Must be a domestic Corporation or LLC
- Must have only allowable shareholders – these include individuals and some (but not all) trusts and estates, but partnerships, corporations and foreign shareholders are not allowed
- Must have only one class of stock
- Must be an eligible corporation – examples of those not allowed include some financial institutions and insurance companies
- Must submit Form 2553 to secure S Corporation status
An LLC can take on the S Corporation tax status to benefit from the tax and other advantages that it offers. To start an LLC with S Corporation taxation, it is first necessary to start an LLC. Businesses cannot start out with the S Corporation tax code, so setting up an LLC is your starting point. Once your LLC is establish you will need to determine a reasonable salary to pay all owner/shareholders and then setup a payroll to pay wages. Once your payroll has been setup you will need to complete and file form 2553 with the IRS and wait for the IRS to accept your S Corporation election.
Why would you choose an S corporation?
First, its important to note that S Corporation is a tax status, not a legal business structure. S Corporation tax status can be very beneficial for an LLC as it allows owner/members to avoid self-employment tax on distributed income. For Corporations it allows them to avoid “double-taxation” by allowing profits to be passed-through to owner/shareholders.
What is difference between C Corp and S Corp?
A C Corp is a legal business structure while S Corp refers to an elective taxation status. By filing form 2553 a C Corp can obtain S Corporation tax status and avoid “double-taxation”.
How an S Corp is taxed?
Entities that obtain S Corp taxation status allow profits to be passed-through to the owners directly. The business owners then pay taxes on that distributed income on their personal income tax return.
Is an S corporation the same as a sole proprietorship?
No, S Corporation refers to a taxation status and a sole proprietorship is a legal structure of a business that is not formally incorporated or formed as an LLC. While S Corporation taxation status and a Sole Proprietorship allow for pass-through taxation, a Sole Proprietor cannot be an S Corp.