Deciding which type of corporation is the best for your business can be a confusing and tedious task. Two types of corporations are recognized by the Internal Revenue Service for the purpose of federal income tax imposition: C corporations and S corporations. An S corporation is a special structure of business ownership by which the business is able to avoid double taxation because it is not required to pay corporate income tax on the profits of the company. All profits/losses are passed on directly to the shareholders of the company. The shareholders file individual tax returns and pay income tax on whatever share of profits they receive from the business. If the business has more than one shareholder the business must file an informational tax return to provide details of the corporate income of each shareholder. This article will talk in detail about the positives and negatives of incorporating a company as an S corporation.
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The Why / What / Who about S Corporations
What is an S Corporation?
An S corporation is a regular corporation that has elected "S corporation" tax status. Forming an S corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or a partner.
In a regular corporation (also known as a C Corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money they receive from the corporation as salary, bonuses, or dividends.
By contrast, in an S corporation, all business profits "pass through" to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships, and LLCs). The S corporation itself does not pay any income tax, although an S corporation with more than one owner must file an informational tax return, like a partnership or LLC, to report each shareholder's portion of the corporate income.
Most states follow the federal pattern when taxing S corporations: They don't impose a corporate tax, choosing instead to tax the business's profits on the shareholders' personal tax returns. About half a dozen states, however, tax an S corporation like a regular corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.
Pros of S Corporation Status
No Corporate Tax: The biggest attraction of this business ownership is the tax advantages. The profits and losses of the business pass through to the corporation owner's personal income tax. Like a Limited Liability Company, the tax "pass through" allows you to avoid "double taxation".
Reduce Taxable Gains: Selling your business can be part of your retirement strategy. An S corporation could have reduced taxable gains when the business is sold.
Write off Start-up Losses: In the early years of starting a business, you will have many expenses and losses. These can be offset against your personal income. A regular corporation would have the losses locked within the company and not applied to your income.
Liability Protection: S corporations offer protection against liabilities. However, liability protection is not complete protection. You can be personal liable for your actions. As well as, many lenders are now requiring personal guarantees.
Cons of S Corporation Status
One Class of Stock: Choosing an S Corporation status will limit your organization to issuing one class of stock. Not having the ability to issue different classes of stock affords a business less control over the company and limitations on the stock value.
Less Attraction for Outside Investors: Growing your company requires money. If you will need venture capital, the regular corporation structure will be a better choice. Venture capitalists will not want to see the pass through tax setup or a limit of 75 shareholders.
Tax Filing: Unlike a non-corporate business structure, you avoid corporate taxes but will still have to file a tax return every year.
Corporate Meetings: Your status is still a corporation with the requirements of having regular meetings and maintaining company minutes. Consider the added time in operating an S Corporation.
S Corporation Facts
S corporations limit owners' liability and offer the tax structure of a partnership. Many entrepreneurs have two goals when choosing a structure for their business: protecting their personal assets from business claims (limited liability) and having business profits taxed on their individual tax returns. Not long ago, an S corporation was the only choice for these business owners. In recent years, however, S corporations have been largely replaced by limited liability companies (LLCs). Still, some businesses can benefit by organizing as S corporations.
Should You Elect S Corporation Status?
Operating as an S corporation may be wise for several reasons:
Forming an S corporation generally allows you to pass business losses through to your personal income tax return, where you can use it to offset any income that you (and your spouse, if you're married) have from other sources.
When you sell your S corporation, your taxable gain on the sale of the business can be less than it would have been had you operated the business as a regular corporation.
S corporation shareholders are not subject to self-employment taxes (active LLC owners are). These taxes, which add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.
Aside from the benefits, S corporations impose strict requirements. Here are the main rules:
Each S corporation shareholder must be a U.S. citizen or resident.
S corporations may not have more than 100 shareholders.
S corporation profits and losses may be allocated only in proportion to each shareholder's interest in the business.
An S corporation shareholder may not deduct corporate losses that exceed his or her "basis" in corporate stock -- which equals the amount of the shareholder's investment in the company plus or minus a few adjustments.
S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.
Fortunately, a decision to elect to be an S corporation isn't permanent. If your business later becomes more profitable and you find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain amount of time.