Choosing an S-Corporation Election
Choosing an S-Corporation Election
Choosing an S-Corporation Election at the right time is important to the success of your business. The business structure you choose influences everything from day-to-day operations, to taxes, to your ability to raise money, and to how much of your personal assets are at risk.
Whether you are just starting your business, or have been operating as a sole proprietor or partnership, you may be wondering about the advantages of running your business as an S corporation.
What is an S Corporation?
S corporation stands for Subchapter S corporation, or sometimes Small Business Corporation. It’s a special tax status granted by the IRS that allows corporations pass their corporate income, losses, deductions and credits through to their shareholders (owners) for federal tax purposes.
As an S corporation, your legal entity is the corporation or LLC, but your taxable entity is the S corporation. S corporations enjoy the same protection from liability as shareholders of a C corporation however, unlike a regular corporation, shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rate. This allows S corporations to avoid double taxation on the corporate income. For some business owners, this is the best of both worlds: liability protection and personal taxation.
What are the Qualifications?
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Violations of any of the above qualifications nullify the S corporation status of an LLC or corporation.
In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders.
Pros of Being an S corporation
The advantages of having an S corporation outweigh any perceived disadvantages. Sole proprietorship and general partnership offer passed-through taxation, but some of the advantages below are not provided by these business types.
Shareholders are not responsible for the corporation’s business debts and liabilities. S corporations protect all personal assets of the shareholders, and creditors are not allowed to pursue shareholder assets like real estate properties, bank accounts, etc.
Since S corporations don’t pay federal taxes on the corporate level, they can avoid double taxation by passing all income and losses to the shareholders who report taxes on their personal income tax returns.
Tax Favorable Characterization of income
Shareholders of an S corporation can be employees of the company and draw salaries as employees. They can also still receive dividends and other distributions that are tax-free to the level of their investment in the business.
Straightforward Transfer of ownership
For LLC or partnership, transfer of greater than 50 percent interest can lead to the closure of the business. For S corporations, interests can be transferred freely without corresponding tax penalties.
With an S corporation making a formal commitment to the business, it is easier for new businesses to establish credibility with potential customers, vendors, partners, and employees.
Ease of conversion
If the S corporation is terminated, there is no paperwork to be filed since it’s only a tax status. On the other hand, LLCs are required to convert to a corporation by submitting needed documents to the secretary of state.
Room for investors
S corporations are allowed to have at most 100 shareholders.
Cons of Being an S corporation
An S corporation may have some potential disadvantages, including:
Formation and ongoing expenses
An S corporation needs to be formed by filing articles of incorporation with the corresponding payments and reports. Many states also impose ongoing fees, such as annual reports and/or franchise tax fees.
Tax qualification obligations
Errors and inconsistencies in relation to the election, consent, notification, stock ownership and filing requirements might result in the termination of S corporation status.
An S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.
Stock ownership restrictions
S corporations are only allowed to have only one class of stock. The number of shareholders is limited to 100 and only U.S. citizens and residents are allowed to be investors.
Closer IRS scrutiny
Because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality. As a result, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.
Since an S corporation is similar to a regular corporation, it is required to adopt all laws imposed by its home state and any state where it is registered to do business.
Owners and officers are required by the IRS to make a salary even if the company hasn’t made any profits yet. This could be a challenge to new businesses still struggling to have a payroll.
Taxable fringe benefits
Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation
Should I Make the Switch to S corporation?
A major reason for choosing S corp taxation is to save money on self-employment taxes.
If an LLC is taxed like a sole proprietorship or partnership; owners are self-employed, and they pay Social Security and Medicare taxes on all business profits, up to federal limits.
If an LLC is taxed as an S corp, the owners can be company employees. They must pay themselves a reasonable salary for the kind of work they do. They’ll pay Medicare and Social Security taxes on that salary, but not on any additional company profits.
Another possible advantage comes from the Tax Cuts and Jobs Act. That tax reform bill gives pass-through entities a 20% qualified business income deduction.
However, tax advantages may not always offer enough benefits to offset other costs of conducting business as a corporation. Switching to an S corp comes with operational costs and administrative burdens. It can mean complex record-keeping and paperwork, as well as expenses associated with incorporation. You’ll need to run payroll, consider state workers’ compensation and unemployment programs, and you may have additional tax forms to file. A good accountant to help you take full advantage of an S-Corp’s benefits is an additional front-end expense.
It’s best to elect your LLC to be taxed as an S corp once you hit the $90,000-a-year mark. This allows you to divide the income between salary and distributions and gets you to a lower overall tax rate. You also need to consider the cost of business tax return preparation as your S corporation needs to file a separate tax return. CPA fees should not be higher than S corporation tax savings. $90,000 annual mark is usually where that plays out. Before then, it’s best to keep your business as a sole proprietorship.
If you are interested to learn more about ways you can increase your tax deductions and lower your tax, schedule a free consultation.