Perspectives
So You Want To Start a S-Corporation?
S-corporations have long been one of the favorite entities of business owners when it comes time to choose the corporate and tax structure for their business. The purpose of this blog is to present pros and cons of S-corporations and to encourage readers to learn more about whether operating as a S-corporation is the best entity for their business.
PROS
1. Avoid “Double Taxation”. In certain circumstances, a S-Corporation can distribute income to shareholders without having to pay taxes at the corporate and at the individual level. When taxes are paid at both levels, this is referred to as “double taxation” and should generally be avoided if your goal is to minimize your required tax obligations.
2. Maximize the Benefit of Losses. While the name of the game is to make and retain the money generated by your business, losses derived through the operation of a S-corporation can be desirable. The S-corporation can pass losses to shareholders who can use the losses to offset other income they receive. Pass-through losses can be especially useful in the early years of doing business when losses often exceed profits and active shareholders may not have quit their day jobs. The ability to pass through distributions and losses also can benefit non-active shareholders who can accept distributions as passive income which can be offset by passive losses that may have accumulated.
3. Liability Shield. A S-corporation offers a liability shield to shareholders and officers such that if the corporate formalities are followed, no personal guarantees signed, laws regarding trust tax and other obligations are followed, the assets of shareholders and officers should not be put at risk by participating in the operation of the business entity. By electing to be a S-corporation, shareholders can have the benefit of income and losses passed through to them as they would in a general partnership without having the exposure to liability for the acts of other partners as is the case with a general partnership.
4. Self-Employment Taxes. An individual who is a shareholder and an employee of a S-Corporation does not have to pay self-employment tax. The reason for this is that wages for such individuals are report on a W-2 and Social Security and Medicare have already been withheld. This is beneficial when one considers that an alternative to this structure could be a single-member LLC where the sole owner (member) would be required to pay self-employment taxes on all income generated through the business.
5. Formation. A business with a traditional corporate structure elects to become a S-corporation by filing Form 2553 with the IRS. If the underlying corporate entity is an LLC, the entity must first elect to be taxed as a corporation by filing IRS Form 8832 and then can proceed with the S-corporation election. We have found that our small business clients often choose to start with an LLC for ease of management purposes and then seek S-status taxation to gain the benefits associated with being taxed as a S-corporation.
CONS
1. Limit on number of owners. A S-corporation is limited to 100 shareholders or less. A C-corporation does not impose any limitations on the number of owners.
2. Capital structure limits. In a C-corporation, multiple classes of stock are permitted. In a S-corporation, only one class of stock is permitted. Additionally, distributions and allocations are made pro-rata based on ownership.
3. More recordkeeping may be necessary. A S-corporation may require more record keeping that a C-corporation. In S-corporations, the basis in shareholder’s stock and accumulated adjustments must be calculated in order to determine the taxability of distributions. These extra requirements will likely cost more in terms of services required by a bookkeeper or accountant.
4. When company needs to retain income. A S-corporation may not be the most beneficial entity structure if the business expects that it will need to retain earnings in order to meet its expansion needs as retained earnings would be subject to corporate taxation. A comparison between corporation and individual tax rates would be necessary in this situation to determine whether the S-corporation offers the most favorable tax treatment.
5. Fringe Benefits. In a C-corporation, employee benefits such as Medical, life insurance, education, childcare, and retirement plans can often be deducted by the corporation and offered tax free to the employees. With a S-corporation, there are certain limitation on the corporation to offer these benefits tax free to employees who own more than 2% of the S-corporation stock.
For more information regarding S-corporations or closely held companies in general, contact the author of this blog.