March 03, 2020

What is an S Corporation (S Corp)?

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What is an S Corporation (S Corp)?

It is sometimes tough to decide how you should structure your business to make it as easy as possible, but also make it as profitable as possible. It would help if you also kept in mind that your company will go through a growth stage. So, as you build your business over time, you need to consider long-term strategy and not just something that will meet your needs for today when you are deciding on the business structure. 

An S Corporation also referred to as an S Corp, is one of the three most popular types of entity structures. It combines the limited liability protection of a C Corporations with the tax benefits of a Sole Proprietorship Partnership or an LLC. For most small businesses, the S Corp will be the way to go.

How is an S Corp Different from a C Corp or an LLC?

The C Corporation, S Corporation, and LLC all have several things in common:

  • Considered legal entities owned by shareholders 
  • Enjoy certain protection under the law
  • Help to safeguard personal assets from business activities
  • Allow conducting business with limited personal liability
  • Give an ability to raise capital
  • Allow to separate personal and business credit
  • It can be a little more expensive to set up and have a little more paperwork.

So, what sets the S Corporations apart from the other business structures? There are several areas where you can see the difference:

  • Tax Status: A C Corporation is taxed twice: taxes at the corporate level and a personal level. It can file a special form to be taxed with an S status so it would not have to pay taxes twice. The S Corporation owners report their share of profit and loss in the company on their personal tax returns. The corporation does not need to make quarterly estimated tax payments because it only reports the income, but there is no corporate tax to the company. However, there are monthly payroll taxes. 
  • Audit rate: The S Corp has a much lower (0.4%) audit rate than the LLC (2-4%). 
  • Ownership: The S Corporation is limited to only 100 shareholders, while the LLC can have an unlimited number of owners. It is also restricted on who can be an owner and can only offer one class of stock. At the same time, other business structures can have multiple classes, where the shareholders who own a different class of stock have different rights and obligations. 
  • Payroll: With the S Corporation, you will have to pay salaries (and payroll taxes) and abide by other employer-related rules and regulations. 
  • Formalities: Besides legal and tax paperwork associated with converting to the S Corp, you will also need to go through a formality of determining a reasonable salary and the owners’ distribution according to your net profit and a number of other factors. This means that you need to be up to date on your bookkeeping and accounting throughout the year to make the right decisions on how much you need to pay yourself in dividends and in salary. 
What is an S Corporation (S Corp)?

How to Qualify for an S Corporation Status

As you might expect, forming an S Corporation is an involved process. The S Corporations get their name from a unique section of the Internal Revenue Service code. They are formed as the C Corporations, and then you must file a form called 2553 with the IRS to elect to be taxed with the S status. 

For most small businesses, the requirements are relatively easy to meet. However, if you are an existing C Corporation, it is harder to convert. If you previously were a C corporation and elected S status within the last ten years, you can face the corporate tax. This can be avoided if you file an S election within 75 days of forming your corporation. 

You will need to pay a flat fee when filing articles of incorporation and also identify a registered agent (the cost may vary from an agent to an agent, but an agent is not tied to a state) to provide a legal address where there are people available during normal business hours to facilitate the legal service of process being served in the event of a lawsuit.

Other requirements include electing directors, issuing stock certificates to initial shareholders, and creating corporate bylaws during the registration process. The business should also comply with shareholder restrictions, which include:

  • No more than 100 owners
  • Must be US Citizen/Resident
  • It cannot be LLC, C Corp, Other S Corp, Partnerships, or certain trusts.

Advantages and Benefits of an S Corp

A corporation can eliminate the disadvantage of double taxation of corporate income and shareholder dividends by applying for the S Corporation status. You do not need to have your company formed as a corporation in order to get the tax benefits of the S Corporation. You can have your entity be an LLC, and it can elect to be taxed as the S Corporation.

S Corp is the best tool to mitigate self-employment taxes. You will be able to split your income – the dividend will not be subject to self-employment taxes, but the salary that corporation pays you will be subject to self-employment taxes. 

Another major advantage of the S Corporation is that if corporate formalities are followed, they typically provide a high level of personal liability protection for its owners. This means that business owners are generally not personally responsible for business debts and liabilities. The S Corps also enjoy a 0.4% audit rate, compared to a 2-4% audit rate for LLC, so the audit rate risk is a lot lower. 

Drawbacks of an S Corporation

The S Corporations need to hold annual meetings and record meeting minutes. Shareholder restrictions for the S Corp can also be considered a drawback depending on the business you have. A major drawback here is considered an ability to offer just one class of stock, which might translate into fewer investors who are attracted to the company. 

Although, when you become the S Corp, you get an opportunity to reduce and mitigate your taxes, remember that it is only a portion of your net income or net profit that is going to be mitigated. Thus, you will have to make sure that your savings outweigh the costs. 

With the S Corporation, you will have to get a payroll system, you will have a bigger tax return (a 1120S form, which is more complex than the Schedule C) and you will probably need some sort of bookkeeping solution. When you set up the S Corp, there are costs involved. So, when you are just starting your business, you might not have any or enough profit (over $30 – $40k) so that the tax mitigation system within the S Corp would offset the costs.

When you are taking part in passive income activities, such as rental real estate, keep in mind that passive income is not subject to self-employment taxes, so you do not put property that you buy and hold under the S Corp. 

Another major drawback of S Corp is that it impacts your Social Security benefits. To be eligible for Social Security benefits, you need to have 40 work credits in a lifetime. You can receive four credits per year, no matter how much you earn. However, your S Corp salary will determine the amount of Social Security benefits you can receive, so reducing your salary to save in self-employment taxes will also reduce your benefits. So, you need to save and invest your tax savings. Also, keep in mind that mortgages and retirement plan contribution limits are tied to your salary. 

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Author: Charles Lutwidge

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