Is Filing an S Corporation Right For You?
Filing an S Corp could help you save money and taxes. But, is it right for you. Find out:
What is an S Corporation?
An S Corporation is a business structure that passes their profiit, losses, and deductions to the owners of the company. This structure also separates the owner’s liability from the business’s.
One of the biggest reasons business owners file S Corps is the tax advantages. As your company grows, tax rates tend to grow as well. S Corps can be a way to “lessen the blow” when it comes to taxes.
S Corporations are actually tax codes created to encourage the formation of small businesses, while countering the double taxation that C Corporations are subject too.
How Are S Corps Different from C Corps and LLCs?
S Corporations are unique structures that come with many advantages compared to C Corporations and LLCs. For one, S Corporations are not subject to corporate income taxes. Instead, they are pass-through entities, similar to LLCs. That means the income of an S Corporation is filed on the personal income taxes of the shareholders. The S Corp itself doesn’t owe taxes.
It’s also easy to transfer ownership of an S Corp. This is because it’s easy to transfer the stock of S Corps, especially compared to LLCs. In this way, S Corps can sell thheir ownership without approval from other shareholders.
S Corporations also hold an advantage over LLCs in the area of self-employment taxes.
While the salary and bonuses of S Corp shareholders are subject to self-employment tax, the profits allocated to them as a shareholder are not. This means that depending on how you pay yourself throughout the year, and how your income appears on your personal tax return, you can minimize your tax burden. Talk to a CPA or tax advisor to discuss how to best do this.
Even with all these benefits, S Corporations aren’t always the best choice for every business. They come with a fair share of restrictions as well.
S Corporation have the following limitations:
There may not be more than 100 shareholders
S Corporations must be domestic business entities
Shareholders of S Corporations must be legal residents of the US, or be US citizens.
S Corporations are restricted to only one class of stock.
While S Corporations offer tax advantages and ease of ownershhip transfer, they also come with restrictions.
Because S Corporations cannot be publicly traded, or have international shareholders, C Corporations may be a better choice for those who want many shareholders. C Corporations have no limits on ownership. C Corporations can also offer multiple classes of stock.
However, if you’re running a business based in the US, and don’t care about ownership limitations, an S Corporation may be right for you.
The Benefits of S Corporations
S Corporations come with several advantages if your company qualifies:
Tax Advantages
S Corporations are mostly exempt from federal income tax – save for capital gains and passive income. Additionally, similar to LLCs, S Corporations allow for pass-through taxation. That means income is taxed on shareholder’s personal tax return.
Multiple ways to categorize income
Owners of S Corporations have flexibility in how they categorize their income for tax purposes. For example, as the owner of an S Corp, you can categorize yourself as an employee of the business and get paid a salary. You can also receive dividends or distributions that are tax-free or taxed at a rate lower than employee salary.
This will reduce your personal tax liability as long as you categorize your salary in a reasonable way.
Asset separation and protection
If your business is an S Corporation, you have certain legal protections for your personal assets which are separate from the assets of the business. For example, shareholders are not personally liable for the company’s debts or liabilities, and for the most part, creditors are not able to go after the shareholders’ personal assets in order to recover business debts.
Easy to transfer ownership
S Corporation ownership interests are easy to transfer to other owners without causing significant tax consequences or ending the corporation.
Downsides of S Corporations
S Corporations aren’t right for every business. They come with their own set of downsides:
Ownership Restriction
S Corporations come with many restrictions on ownership. S Corps can only offer one class of stock, which can be limiting to potential investors. S Corporations are also capped at 100 shareholders, and these shareholders must be legal US citizens or legal residents.
Tax Issues
Sometimes S Corp owners make tax mistakes related to stock ownership and other aspects of running S Corps. This can led to their S Corp status being revoked.
Wage and Dividend Warnings
S Corporations come with lots of flexibility regarding income categorization. However, the IRS is always looking for business owners that are too liberal with their accounting. This said, S Corp owners are at risk of being asked to re-categorize their income and pay higher taxes.
Requirements Necessary to File an S Corp
There are qualifications needed for S Corporation Status. Here are the requirements you must meet, according to the IRS:
1. Be Based in The US
2. Have 100 or fewer shareholders that are legal US Residents or US citizens
3. Have only one class of stock
4. Cannot be an ineligible corporations. Some examples of ineligible corporations are financial institutions, insurance companies, and domestic international sales corporations.
5. Must submit Form 2553 to elect S Corporation status for tax purposes.
What Makes S Corps Different From C Corps and LLCs
Here’s How C Corporations Compare to Other Entities:
Differences between types of business entities
The main difference between these business entities is the way these businesses are taxed.
Entity Type
LLC
C-Corp
S-Corp
Non-Profit
Has to file a separate tax return
Varies
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Frequently Asked Questions About S Corporations
Can foreign residents be shareholders in S Corporations?
Shareholders in S Corporations must be legal US residents or US citizens. That said, in order to be a shareholder who is foreign, you would need to be classified as a “Resident Alien”. This means you can legally work and pay taxes in the US. You should also possess a Social Security Number (SSN) or individual tax ID.
Do S Corporations Have a Limited Amount of Shareholders?
Prior to 2004, S Corporations were limited to 75 sharehholders. Post 2004, S Corporations are limited to 100 shareholders.
Which corporation offers the best tax advantages?
The two main types of corporations are S-Corporations and C-Corporations. Upon formation, all corporations are considered C Corps. This distinction is made on the federal level.
Corporations that want to be taxed as a small business should file Form 2253, the form that is used to apply for S Corporation status. This allows you to avoid the double taxation C Corporations are subject to. Instead, your business’s taxes are passed through to your personal tax return. Additionally, you have flexibility in how you categorize your income when you have a S Corporation.
Corporation that want to be taxed a small business corporation file a form with the IRS called Form 2553 and will file their taxes using 1120s tax return. Corporations that do not file this form are taxed as traditional corporations and file the 1120 tax return.A C-corporation file a corporate tax return and will pay taxes on the profits. The post tax income may then be distributed to the corporation shareholders in the the form of dividends. The shareholders are then taxed on dividends, which effectively forces the ownership of a corporation to pay taxes on the same earnings twice- once at the corporate level, and then as individual level. This is what is known as “double taxation.”
