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Whether you’re just starting out or if you’re thinking about expanding, you need to consider which legal structure is best for your business. No one option is best for every type of business. In fact, the right choice depends on several factors, including your business goals, the number of owners, and taxation.
There are many legal structures you can choose from – including sole proprietorship, general partnership, Limited Liability Company (LLC), or corporations (C Corp and S Corp). If you’re leaning toward corporations, particularly S Corporations, you may be wondering about the pros and cons of setting up your business as an S Corp.
Keep reading to discover the pros and cons of S Corporations, as well as how to set one up.
What is an S Corporation?
First things first: What exactly is an S Corporation?
Commonly called an S Corp or an S subchapter, an S Corporation is NOT a type of business entity – instead, it is an IRS classification. For federal tax purposes, it is a corporation that’s treated as a pass-through entity. If a business is considered a pass-through entity, that means that its losses, deductions, credits, and profits are passed along to its owners who are known as shareholders. Then, the owners have to report this information – and pay any and all associated taxes – on their personal income tax returns.
How to obtain an S Corporation status
To obtain an S Corporation status, a business has to meet specific IRS requirements. As per the IRS website, these qualifications include:
- 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).
The pros of S Corps
S Corporations provide numerous benefits to shareholders, particularly in the areas of taxes and liability protection. Here are some of the pros of S Corps:
- Pass-through taxation
One of the primary benefits of filing as an S corporation is that you avoid double taxation as S Corps do NOT pay business taxes. Instead, business losses or profits are passed through to shareholders who then have to report it on their individual tax returns. Moreover, because income is taxed to the shareholders, you can avoid problems arising from the corporate alternative minimum tax.
Just a reminder: Make sure to check with the state where your business operates as some don’t provide tax breaks afforded to S Corps and instead taxes businesses as a regular corporation.
- Liability protection
Another advantage of the S Corp structure is that it provides each owner with personal liability protection. With an S Corp structure, the personal assets of the owners are protected – there’s no personal responsibility for the company’s liabilities and debts, which means that personal assets can’t be seized as payment. For instance, if your company is unable to pay off its debts, your business assets would be open to creditors, but your personal belongings are strictly off-limits.
- Reduced self-employment tax
With an S Corp structure, taxable business income is divided into two parts: salary and distribution. S Corp shareholders can be both employees and owners, which means that you can earn a salary.
On the salary portion, you’ll only pay self-employment tax, such as Medicare taxes and Social Security taxes. Altogether, this allows you to gain some control over your tax liabilities – the lower the salary, the fewer taxes you owe.
A reminder: To maintain S Corp status, you have to pay yourself a reasonable salary. Note that the IRS could view an unreasonable division as an attempt to avoid paying taxes and they may revoke your S Corp eligibility.
The cons of S Corps
Every business structure has drawbacks. Here are some of the cons of S Corps that you need to be aware of:
- Strict management requirements
To maintain its S Corp eligibility, your business has to follow a number of rules. For instance, you can’t have more than 100 owners, and you’re limited to only one stock class. Also, owners must be paid a reasonable salary based on current market conditions. While the IRS doesn’t specify any salary numbers, you can find related guidelines in Publication 535, under ‘Test 1 –Reasonableness’.
- Not recognized in every state
Some jurisdictions and states don’t recognize federal S Corporations. They may charge state fees and taxes as if you’re a traditional corporation. The law surrounding S Corporations can be complex and it varies widely by location, so make sure to review your state’s laws.
Most people only see the tax advantages when they think of S Corporations (and with good reason!). However, the S Corporation setup can bring some tax disadvantages as well, such as:
- Arbitrary taxation. The income of an S Corp’s shareholder is taxed – whether it is reinvested or distributed to the shareholders. On the other hand, this is a different case when it comes to C Corporations.
- Salaries. To prevent S Corp owners-employees from avoiding employee taxes, the IRS mandates S Corporations to pay reasonable salaries to all employee-shareholders of the corporation. This requirement applies regardless of whether the business is making a profit or not. This can stifle the growth of an S Corporation, particularly those that are just starting out.
Starting an S Corporation
After weighing the pros and cons, if you’re still determined to establish your business as an S Corp, here are your next steps:
Step 1. Submit your articles of incorporation.
The first thing that you should do is to fill out and file the form for articles of incorporation (also known as a certificate of incorporation), with your secretary of state’s office. The form includes the basics of your business, including its name, address, incorporators, and purpose.
Step 2. Initiate applying for S Corp status with the IRS.
Once your state office has accepted the forms and approved them, you need to complete and submit Form 2553, Election by a Small Business Corporation – the document that you use to apply for S Corp status. You can find this form at any local IRS office or on the IRS website. Each shareholder is required to sign it before you submit the form to the IRS. Also, you must file it by March 15 of the tax year in which your business chooses to become an S Corporation. The IRS will review your application to ensure that your business meets all of the eligibility requirements they have set for S Corporations.
The bottom line
S Corporations come with their own pros and cons, so make sure to weigh them carefully before you apply for S Corp status. For specific questions on which business structure is best for your business, it is best to consult an accountant or attorney.