If you have been operating as a sole proprietorship or a general partnership, you may benefit from incorporating your business as an S corporation (S corp).
Along with having your business treated as a pass-through entity by the IRS, thereby avoiding double taxation, structuring your enterprise as an S corp offers several other advantages.
Absent an express personal guarantee, shareholders of an S corp are not personally responsible for liabilities of the business. Personal assets including real estate and bank accounts cannot be pursued by creditors to pay for business debts.
This limited liability protection is a stark difference compared to a sole proprietorship or general partnership where the owners and the business considered to be the same legal entity.
S corps do not pay corporate taxes at the federal level. Business income or losses are “passed through” to shareholders to be reported on their individual personal income tax returns. In addition to avoiding double taxation, pass-through treatment allows shareholders to offset other income with business losses.
Favorable taxation of income
Business owners can lower their overall tax burden by characterizing a reasonable distribution of money received from the business as salary or dividends. This strategy reduces self-employment tax liability for shareholders while creating tax deductions for the corporation.
Ownership transfer, termination and accounting flexibility
Additional S corp advantages include:
- Straightforward transfer of ownership
- Easy termination of corporate status
- Choice of cash or accrual accounting method
Disadvantages of the S corp structure
- Can only issue one class of stock, having identical rights regarding dividends and asset distribution in the event of a liquidation (can make it more difficult to raise cash)
- Appreciated assets cannot be distributed to owners without first being taxed
- Pulling assets out of an S corp can be an administrative challenge as all withdrawals must be characterized for tax purposes as compensation, dividends, a loan or other payments (each characterization triggers additional document filings)
- The IRS tends to scrutinize S corp salaries to ensure that shareholder-employees are receiving reasonable compensation for their services (Read Why is Reasonable Compensation Important? to learn about Accountability Services’ tool for keeping business owners in compliance)
- Profits and losses must be distributed equally, based off the percentage of ownership
- Compliance rules may hinder the growth of certain businesses
- Annual fees, while minor and deductible as expenses, are required to maintain S corp status
How to qualify for S corp status
The first step of forming an S corp is no different than incorporating into a C corp. An S corp is simply a corporation that meets certain requirement for a “tax election” option under Subchapter S of the Internal Revenue Code.
A corporation qualifies for S corp status by meeting the following:
- Is a domestic corporation with a maximum of 100 shareholders
- Has only allowable shareholders – cannot have partnerships, corporations or non-resident alien shareholders
- Has only one class of stock
- Does not operate in an ineligible industry – certain financial institutions, insurance companies, and domestic international sales corporations are disallowed
To apply for S corp status, file Form 2553 (Election by a Small Business Corporation) with the IRS. Note that all shareholders must sign the consent statement or the tax election will be denied.
S Corp versus an LLC
For some small businesses, a Limited Liability Corporation (LLC) may be a better fit than an S corp for achieving asset protection. An LLC offers a greater degree of freedom and fewer formalities than an S corp but can be subject to higher self-employment tax. Companies often form as an LLC during the startup phase and then change their legal entity to an S corp as the business grows and matures.
Both entities provide distinct pros and cons that business owners must weigh to determine which structure is more advantageous given the sum of all relevant factors and future goals.
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Schedule an advisory session with an experienced Seattle accountant
Whether you are setting up a new company or have already been in business for years, it is always a good idea to periodically evaluate which legal structure is the best fit for your unique financial goals and business needs.
Accountability Services is here to help.
To book an advisory session to discuss the advantages and disadvantages of setting up an S corp or LLC for your enterprise, please email MasterPlan@AccountabilityServices.com or call our Seattle CPAs at 206.522.0110.