A subchapter S corporation (S corporation) is a type of business structure that offers some advantages over other types of corporations. An S corporation can help you reduce your taxes and protect your personal assets, but it also has disadvantages. Understandably, the favorable tax implications might outweigh any drawbacks for many business owners who are considering an S corporation as their company’s legal structure. Here is a look at some of the pros and cons of establishing an S corporation as your business entity.
What Is an S-corp?
An S corporation is a type of business entity that is set up as a corporation but is taxed as a sole proprietorship or partnership, rather than as a corporation. The S corp designation is based on the type of taxation applied. An S corporation has shareholders, just like a C corporation, but it is not taxed as a regular corporation. A regular corporation is taxed twice: first, the corporation pays taxes on its net income, and then the owners pay taxes on any dividends they receive from the corporation’s profits. In contrast, an S corporation is only taxed once, just like a partnership or sole proprietorship.
Pros of an S Corp
There are several advantages of an S corporation. The most important of these is that the owners can avoid paying corporate taxes on their profits. Since the S corporation is taxed as a sole proprietorship or partnership, its profits are only taxed once, at the owner’s level. In addition, owners of an S corporation can receive distributions of profits in the form of tax-free salaries and distributions of taxable dividends. All other types of corporations must pay corporate taxes on the profits they distribute to shareholders. An S corporation also provides some limited liability protection for the owners. The owners’ risk of being sued by creditors or being subject to a lawsuit from a former employee is lower than with other types of corporations.
Cons of an S Corp
The main drawback of an S corporation is that it does not have the same favorable tax treatment as a C corporation. An S corporation is not allowed to claim deductions for salaries and other expenses, such as insurance and certain business expenses. Such deductions are available to C corporations. An S corporation also does not have the same ability to grow that a C corporation has. The S corporation is only taxed at the individual owner’s rate, which is lower than the corporate tax rate. A C corporation can grow and retain earnings, which can be reinvested in the business. As a result, a C corporation can grow much faster than an S corporation.
An S corporation also has other disadvantages, including the following: – Because S corporations are relatively uncommon, banks and investors may be less willing to provide financing to the owners of an S corporation. – There are some restrictions on who can own an S corporation. In general, only United States citizens and legal aliens can be shareholders of an S corporation. – The accounting and administrative requirements for an S corporation are more complicated than for a C corporation.
Key Takeaway: Should You Incorporate as an S Corp?
Choosing between a C corporation and an S corporation can be a difficult decision for business owners. The advantages and disadvantages of each type of corporation vary by industry. As a general rule, a C corporation is more appropriate for businesses that expect their profits to be substantial and rising. An S corporation is more appropriate for businesses that expect profits to be relatively low and relatively constant. In some industries, it’s easier to make the case that a C corporation is more appropriate. In others, it’s easy to make the case for an S corporation. For many businesses, the best approach is to incorporate as a C corporation now and then consider converting to an S corporation later. Doing so can allow a business to take advantage of the advantages of both corporations.
How to Form an S Corp
Forming an S corporation is generally a five-step process. You or your business attorney will need to: – Draft a corporate operating agreement. This should include details on the shares of stock issued, how the business will be managed, and how profits will be distributed. – File articles of incorporation with the state. This is the document that creates your corporation and includes the operating agreement. – Hold a meeting of shareholders. The shareholders must vote to approve the articles of incorporation and the corporate operating agreement. – Obtain an Employer Identification Number. You will need this to pay federal and state income taxes. – Obtain a federal tax identification number. This is the Employer Identification Number that you applied for in Step 4 above.
What Are the Tax Benefits of an S Corp?
The major tax benefit of an S corporation is that it is not taxed as a corporation. Shareholders are taxed on the profits at their personal tax rates, which are typically lower than corporate tax rates. An S corporation owner can deduct his or her business expenses from their personal income taxes. The remaining profit is taxed at the owner’s lower tax rate. C corporations have to itemize deductions on their taxes and many qualified deductions are not allowed for C corporation owners. – Interest expenses are deductible for S corporations, but not for C corporations. Interest is a major expense for many businesses, particularly for those that borrow money to expand. – Stock options and employee stock purchase plans are less valuable when incorporated as an S corporation because they do not qualify as a deduction against corporate income. – The S corporation may qualify to use the cash method of accounting and the lower corporate tax rates. A C corporation is generally required to use the accrual method and the higher corporate tax rates.
Disadvantages of an S Corp
As mentioned, an S corporation has some disadvantages. For example, rules surrounding who can be a shareholder of an S corporation are more strict than those of a C corporation. An S corporation must also be dissolved if there is only one owner. An S corporation in a high-income bracket state may be subject to higher taxes and more complicated tax computations than a C corporation. An S corporation may have more administrative requirements and more problems obtaining financing than a C corporation.
Choosing between a C corporation and an S corporation can be a difficult decision for business owners. The advantages and disadvantages of each type of corporation vary by industry. For many businesses, the best approach is to incorporate as a C corporation now and then consider converting to an S corporation later. Doing so can allow a business to take advantage of the advantages of both corporations.