Is an S Corporation the right entity type for you?

This is a great question to explore when starting a business, or changing your existing business from a Sole Proprietor or General Partnership. It can make a difference in asset protection as well as in taxes. An S Corporation is one of the three popular choices for those incorporating their business. Other choices include Limited Liability Companies (LLCs) and C Corporations.

Business owners can select how they wish to be taxed, and an S Corporation is one of those tax designations that can make a big difference in how much you pay in taxes, and how to handle profits and distribute shares. There are pros and cons to every entity type and it’s important to understand which business model is best for you.

An S Corporation is a corporation that has elected to be taxed as a flow-through entity (similar to an LLC or Limited Partnership). The “S” also refers to an IRS code section. This type of taxation, the S election, allows the shareholders to be taxed only at the individual level only instead of at both the corporate and individual level, thus avoiding the double taxation like the C Corporation.

Of all of the entities, the S Corporation has the tightest restrictions on ownership. There can only be 100 or fewer shareholders (owners), which all must be individuals or their living trusts. Corporations, multi-member LLCs, and non-US residents cannot be S Corporation owners. If the restrictions aren’t followed, the IRS will decide the corporation is C Corp and will double tax it accordingly.

S Corporations can help some service-oriented businesses to avoid being characterized as a Personal Service Corporation, or “PSC” by the IRS. PSCs are C Corporations that are classified by the IRS as providing a service, such as consulting, to the general public.

Now, as you may know, the IRS assesses C Corporations with a pretty low initial rate — 15% on earnings up to $50,000. That’s quite a bit lower than you would pay personally if you were receiving that same $50,000 as salary. And, that 15% rate is also lower than you would pay if your business was an S Corporation. So, to head off the anticipated revenue drain, the IRS closed the loophole by designating C Corporations that provide services as PSCs.

The tax rate for PSC earnings? 35%! That’s probably higher than you would pay through your S Corporation if you took a reasonable salary and the rest as passive income. And, it’s enough, in many cases, to make the difference between going “S” or going “C.” Again, you will work with your CPA, tax and/or legal advisors to determine the best entity for your specific situation.

Advantages Of S Corporations:

• Limited liability for management and shareholders.
• An unlimited number of management, no state residency requirements.
• Distinct, court-recognized existence, which helps protect you from personal liability that can cause you to lose your personal wealth in assets like your home, car, or nest egg.
• Flow-through taxation: Profits are distributed to the shareholders, who are taxed on profits at their personal level.
• Good privacy protection, especially in Nevada and Wyoming.
• Great income-splitting potential for owner/employees. Can take a smaller salary and pay income taxes and regular payroll deductions, then take the remainder of profit as a distribution subject to income tax only.
• S Corporations are great for businesses that:
            • will provide a service (i.e. consultants);
            • will not have significant start-up costs;
            • will not need to make major equipment purchases before beginning operations; and
            • will make a sizable amount of money without a great deal of expense.

Disadvantages Of S Corporations:

• At shareholder level, shares are subject to seizure and sale in court proceedings.
  Maximum of 100 shareholders, all of whom must be U.S. residents or resident aliens. Shares must be held directly, except in special circumstances.
• Owner/employees holding 2% or more of the company’s shares cannot receive tax-free benefits.
• Because flow-through taxes will be paid at the personal rate, high-income shareholders will pay more taxes on their distributions.
• Not suitable for estate planning vehicle, as control is ultimately in the hands of the stockholders. In a planned gifting scenario, once majority control passes to children from parents, children can take full control of the company.
• If tax status is compromised by either non-resident stockholder or stock being placed in corporate entity name, the IRS will revoke status, charge back-taxes for 3 years and impose a further 5-year waiting period to regain tax status.
• Not suitable to hold appreciating investments. Capital gain on sale of assets will incur higher taxes than with other pass-through entities such as LLCs and Limited Partnerships.
• Limited to one class of stock only.

What is needed to form a corporation? How does it protect me?

Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, it — the corporation — is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners’ liability is limited to the monies they used to start the corporation, not all of their other personal assets. In the event of a lawsuit it is the company, not the individuals, being sued.

A corporation is organized by one or more shareholders. Depending upon each state’s law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners’ privacy, nominee officers and directors may be utilized. A corporation’s first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including frequently, the company’s attorney.

The articles of incorporation set out the company’s name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.

Can I change entity types?

Yes, if you think you may want to go public at some point in the future, but want initial losses to flow through, consider starting with an S Corporation or a Limited Liability Company. You can always convert to a C Corporation at a later date, after you have taken advantage of flowing through losses. Corporations can make the election at the beginning of its existence or at the beginning of a new tax year.

More benefits to business owners: No self-employment tax!

The big benefit of S Corporation taxation is that S Corporation shareholders do not have to pay self-employment tax on their share of the business’s profits. But they will be taxed on the salary they pay themselves. This is the catch. Before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary) that is subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kick in once the S Corporation is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

More Questions? An Incorporating Specialist can help!