What the heck is an S-Corp??

“Sufferin’ succotash! What is the deal with that thing called an S-Corp and how do I get me one?”

Yes, in my last blog I told you about the many benefits of an LLC and why most small businesses would benefit from them. But now comes an interesting comparison. The LLC v. the S-Corp.

What is an S-Corp you ask? Well, it is simply a business that elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. The reason a business owner might choose to be taxed as an S-Corp is that it provides the same pass-through taxation of a partnership or LLC, but it has some added tax benefits, including the fact that it greatly reduces the amount of revenues on which the business owner(s) will have to pay self-employment tax.

Sounds good, right? Well, if handled correctly, it can be.

Now, I am not a CPA, so please verify what I have to say here with your own tax advisor and confirm the rules that apply in your state. That said, the benefit of the S-Corp form is that it can save a business owner a large amount in self-employment taxes, something that cannot be said of the LLC. With an LLC, every penny of revenue is subject to self-employment tax.

The S-Corp is looking pretty good right about now, isn’t it?

If you were waiting for the other shoe to drop, listen closely.

I can think of some major reasons why the S-Corp is not for everyone.

First, once you have made your S-Corp election (please run, don’t walk, to your favorite CPA and discuss how to do this, and whether it is the right choice for your situation), there are some heightened requirements that the business owner must satisfy yearly in order to maintain the S-Corp status. For example, the shareholders or members must (I repeat must) adhere to what are called “corporate formalities.” Corporate formalities include holding regular and special meetings, keeping minutes of those meetings at the corporate headquarters (even if that is in the garage next to the treadmill that is used as storage), and using a formal, written corporate resolution to document every single significant decision made on behalf of the organization by those running it. These are not impossible to maintain, and many companies do so happily. In fact, I recommend that even LLCs maintain corporate records on the level of those kept by Corporations and S-Corps. But with an S-Corp, a failure to do it can cause you to lose your S-Corp status. That can mean a whole host of not insignificant tax ramifications, not the smallest of which is that you cannot enjoy the S-Corp status again for another 5 years, even if your company would otherwise qualify for it. What that also means is that your business revenue will then be taxed as a regular corporation, not as a pass-through entity.

And converting from an S-Corp to an LLC (if it became clear that being an LLC was the better option for your business) carries inherent challenges and likely financial penalties to make the switch. Switching from and LLC to an S-Corp is much easier and doesn’t carry the same monetary risks.

The second reason why an S-Corp might not be for everyone is that the shareholders of an S-Corp cannot generally receive special allocations of profits and losses. The details of this go beyond this blog entry today (and remember: I am a lawyer and was “told there would be no math.”), but suffice it to say that it seems to me that it would be much more difficult to raise capital through investors if those investors cannot write off all business losses on their individual tax returns (versus only those in proportion to the amount of their investment).

In contrast, with an LLC, business debt increases the membership tax basis generally. That means that the members can deduct more losses from the business on their individual returns. And the higher the investor or member’s basis, the less capital gains are possible, which ultimately means less tax when he or she sells his or her interest or sells the business. So, although the S-Corp provides the benefit of lower self-employment taxes for its members, it seems to that an inability to utilize business losses and debts could easily off set the benefit of having a smaller self-employment tax.

Regardless of which entity you choose, choice of entity is a state specific thing, and so it is important to consult with a local attorney (or an attorney in your jurisdiction of choice, such as Delaware) to determine which entity is the right one for your business.

Being that I’m no CPA, I welcome comments on how business owners have availed themselves of the benefits of the S-Corp status. And if there are any war stories about how businesses have struggled with or lost the S-Corp status, those would be equally illuminating, so bring them on!

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