Choosing the right business structure for your enterprise is a crucial decision. It has long-lasting ramifications, as it sets the path for the future in terms of operations, management, legal and tax issues. Proper research should be done before you take your pick. There are many business forms to choose from, sole proprietorship, partnership, limited liability company (LLC), corporation or an S corporation. Here we discuss an S Corporation, its structure, advantages, disadvantages and more.
What is an S Corporation?
S Corporation is a variation of a corporation within Subchapter S of Chapter 1 of the Internal Revenue Code. Essentially, an S corp is any business that chooses to pass corporate income, losses, deductions, and credit through shareholders for federal tax purposes, with the benefit of limited liability and relief from “double taxation.” Some 30 million business owners include business profits on their personal income tax returns.
To be an S Corporation, your business first needs to be set up as a corporation by filling and submitting documents like the Articles of Incorporation or Certificate of incorporation to the appropriate government authority, along with the applicable fee. Once the incorporation process is complete, all shareholders must sign and submit Form 2553 to be granted the S Corporation designation. From there, taxes are handled by the corporation's partners on their individual returns. (For related reading, see: Are You an Entrepreneur?)
According to Internal Revenue Service (IRS), to qualify for S corporation status, the corporation must meet the following requirements:
- Be domiciled in the United States;
- Have only allowable shareholders, which may include individuals, certain trusts, and estates, and cannot include partnerships, corporations or non-resident alien shareholders;
- Have 100 or fewer shareholders;
- Have just one class of stock;
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations, which are forbidden the S corp structure).
Avoiding Double Taxation
According to the IRS, “Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. It is treated in the same way as a partnership, in that generally taxes are not paid at the corporate level.” This is one of the most appealing features of an S corporation. By contrast, the taxable income of a regular corporation is subject to double taxation, first at the corporate level, then at the individual income tax level.
For example, a regular "C" corporation has four shareholders with equal share and reports taxable income of $440,000 in a year on which the company needs to pay a corporate tax of 34% ($149,600). The company subsequently distributes the remaining amount ($290,400) among the four shareholders with each shareholder getting $72,600, which is again taxed. (For related reading, see: Understanding Corporate Structure.)
S Corporations have an advantage here, as they are taxed once. The corporate income, loss, credits and deductions are “passed through” to shareholders for tax purposes. The shareholders then report the same on their personal income tax returns (Form 1040), which are according taxed at applicable individual income tax rate. Thus an S Corporation is exempt from paying taxes at the corporate level.
This advantage is not granted to all S Corporations, however, as different states and municipalities have variations in tax laws. New York City, for example, imposes a full corporate income tax of 8.85%, though if that business can prove that it has business outside of the city, that portion can be exempt (for more on the NYC-only tax, click here.) California levies a similar charge — a franchise tax — which is 1.5% on net income, or a minimum of $800.
Here are some more advantages of employing an S corp structure:
- Self-Employment Tax
Employing an S Corporation structure can lower the self-employment tax. The taxable business income can be split into two components — salary and distribution. Here, only the salary component attracts the self-employment tax, thus reducing the overall tax liability. While in the case of a sole proprietorship, partnership or LLC, the self-employment tax is applicable on the entire net business income. The second component of the income comes to the shareholder (owner) as distribution, which is not taxed. By making a “reasonable” division between the two components, there can be a substantial amount of tax savings. It's considered good to draw approximately 60% of the company's income as salary since any unreasonable division could be construed as attempt to avoid taxes.
- Independent Life
Unlike a sole proprietorship or LLC (LLC without necessary inclusions in its operating agreement) where the life of the business is linked to the owner’s life or exit from business, an S Corporation has an independent life span. Its longevity is not dependent on shareholders, whether they depart or stay, thus making it relatively easy to do business and look at long term goals and growth.
- Protective Shield
Personal assets of shareholders are protective by the structure of an S Corp. No shareholder is personally responsible for the liabilities and debts of the business. Creditors have no claim on the personal assets of shareholders in order to settle business debt, whereas personal assets are vulnerable under sole proprietorships or partnerships.
- Transfer of Ownership
It's relatively easy to transfer interest in an S Corporation as compared to other forms of business entities. The sale can be structured in two ways: 1) an outright sale, where the buyer makes the purchase in one go and there is immediate transfer of ownership; or 2) gradual sale, where the purchase is done over a period of time. Whichever way is chosen, the transfer of ownership is facilitated through a written sales agreement which formalizes the whole process. The same ease is not there in a sole proprietorship, which is very simple to form but equally hard to sell to another party.
An S Corporation has high credibility among potential vendors, customers and partners, as an S Corporation is a recognized business structure.
Some Disadvantages, However
S corporations also carry with them some possible disadvantages. Here is an overview:
This form of business entity requires many protocols to be followed, like scheduled meetings of directors and shareholders, meeting minutes, formalized by-laws, maintenance of proper records, and more recordkeeping requirements.
- Compensation Requirements
As discussed earlier, shareholders split corporate income into two parts (salary and distribution). Here, the IRS keeps a closer watch and takes notice of abrupt combinations, such as low salary-high distribution. If this is observed by IRS, then it makes changes accordingly, moving a larger sum under “salary.” which can lead to unexpected higher taxes.
- Extra Work and Cost
As compared to a sole proprietorship, S corporations need more accounting and bookkeeping, which can require the help of a qualified accountant, adding to the costs. In addition, there might be more banking and legal advice needed for business loans, taxation and other issues. Even state governments and agencies levy more fees and taxes. For example, Massachusetts levies an extra tax on profits once the company reaches a specified size.
- Added Restrictions
The IRS has laid down many criteria to quality for the S corporation status which restricts the type and number of shareholders. For example, foreigners can't be shareholders; all the owners need to be U.S. citizens or permanent residents. Even during transfer of ownership, the transfer can only be done to specified individuals, an estate or trusts. Noncompliance can lead to the IRS taking away S corporation status. This restricts the flexibility of the business. In addition, income and losses need to be allocated according to the percentage of ownership, unlike a LLC or partnership where the allocation can be different by setting it up in the operating agreement.
If you have a larger, faster-growing company, sticking with the C corporation might be a better fit. That structure allows multiple classes of stock and no limits on shareholders.
- Tax Changes
In 2013, federal income tax rate increases saw the top rate on individuals who earned $400,000 or more ($450,000 for joint filers) rise to 39.6% from 35% (which also happens to be the top corporate rate). Such changes highlight the necessity to monitor changes to tax rates and laws that could make the S corp structure less attractive compared to the regular corporate structure.)
With features like limited liability and tax savings, the S corporation structure is used by 4.6 million U.S. companies. When compared with sole proprietorships or partnerships, S corporations have an edge on aspects like transfer of ownership and continuance of business. However, S corporations can be disadvantageous for a single-owner, small business (less than $50,000 annually). Before opting for an S corporation, make sure to check about rules and regulations, and especially tax treatment (and any additional fees and taxes) in your state or city. Also, it would be wise to consider hiring an attorney who can advise you on corporate structures. For more information, see the IRS's information page on S corporations. (For related reading, see: The Basics of Corporate Structure.)