Updated June 25, 2020
Most small business owners think they know the difference between C corporations and S corporations, but new tax law changes and common misunderstandings about S corporations often get business owners in trouble with the Internal Revenue Service. S corporations can–but don’t always–save you money when it comes to taxes. There are several reasons why an S corporation might be the right choice for your business entity.
5 Reasons an S Corporation Might Be Right for Your Business
- Provides Personal Asset Protection
- Lowers Your Tax Liability
- Prioritizes Your Privacy
- Offers Limited Liability to Unlimited Managers
- 100% of Your Business Profits Go to Earnings
The S corporation is the appropriate choice for you if you’re a small business owner looking to pull a reasonable salary and protect your investments (house, car, properties, stocks, nest eggs). S corporations usually decrease your tax burden–and your investors’ tax liability–while loosening the eligibility requirements for your investors and providing more privacy protections than most other corporation forms. An S corporation is perfect for you if you have low-to-zero physical overhead, aim to sublimate all yearly earnings into personal income, and do not carry appreciating investments year after year.
1. Provides Personal Asset Protection
If you are currently operating your business as a sole proprietorship or general proprietorship, you could lose your personal assets if your business entity is sued. Besides forming a Limited Liability Corporation (LLC), you have two additional choices for protecting your personal assets: C corporation and S corporation.
C corporations, S corporations, and LLCs all grant the shareholders limited liability, ensuring that your personal assets aren’t exposed to your corporate actions. Both S corporations and LLCs allow pass-through taxation, meaning that S corporations and LLCs do not have to file a corporate tax return, and owners simply report the profit or loss of their share on their individual income tax return.
Filing a business under Chapter “C” in the Internal Revenue Code means that it is a “profit corporation,” and as such is taxed once at the corporate level and again when owners earn taxable income from shares. This is what is referred to as double taxation.
Filing a business under Chapter “S” in the Internal Revenue Code indicates that it will operate like a C-corporation but be taxed in the same way as a non-incorporated business. This allows protection for shareholders while passing earnings or losses directly to owners.
There are certain circumstances where forming a C corporation is more advantageous for business owners than an S corporation, such as when C corporations reinvest retained earnings as a way to lower their taxes.
2. Lowers Your Tax Liability
For small businesses, such as family businesses, professionals, service, sales, or retail, you can register as an S corporation to avoid being labeled as a personal service corporation (PSC) by the IRS and having your profits taxed at a higher rate.
When comparing C corporation vs. S corporation, keep in mind that the IRS will designate any service offered to the general public as a PSC. The tax rate associated with a C corporation that’s labeled a PSC is a whopping 35%.
Forming an S corporation instead would result in tax savings, as long as you earn a reasonable compensation as salary and treat additional earnings as passive income on your tax return. S corporations pay 0% federal income tax, because all income deductions, profits, and losses pass through to individual S corporation shareholders, who then report those profits and losses as taxable income as part of their individual tax returns.
S corporations help with the tax liability of the owner-operators. Incorporating as an S corporation means that your business entity is effectively split from you, the owner. As such, you are then permitted to pay yourself both salary and benefits, but they’re subject to FICA tax. By forming an S corporation and slicing off additional income as passive income, you can avoid paying both portions of social security and Medicare on all of your income, which usually adds up to more than 15%. By dividing up your total earnings between a reasonable compensation figure for your salary and treating the rest as a distribution, your total tax liability is lower because your passive income is taxed at a lower rate.
3. Prioritizes Your Privacy
When you form an S corporation, you’re forming a new legal entity separate and distinct from yourself. This ensures that the corporate entity, not you, is responsible for all of the actions and activities of your business. By incorporating, you are protecting yourself from being personally named in a suit by shielding yourself with the corporate entity.
If your company is threatened by a lawsuit, an S corporation can help protect information regarding your ownership and involvement with the company. Privacy can vary by state: Wyoming provides particularly strong protection, and will not post your name publicly as a member of the corporation. Nevada also affords strong protections, although they do publish the member and managers of the corporation publicly and as such you will need to hire a proxy.
4. Offers Limited Liability to Unlimited Managers
One of the main advantages of an S corporation is that it provides limited liability–not just for your shareholders, but also for management. In addition, you are allowed to appoint unlimited management and are not restricted to any particular state residency requirements as part of your S corporation requirements.
Corporate membership is dictated by the by-laws of your corporation. S corporations allow you to bestow membership upon up to 100 individuals, as long as the shareholder is not a corporation and is a U.S. citizen (or permanent resident). Shareholders in an S corporation must be individuals, estates, or other special tax-exempt trust entities. Family members are counted as one shareholder, so a child and two parents owning S-corporation stock would count as a single shareholder total.
S corporation tax advantages are revoked and penalties are retroactively applied if any share of the S corporation is found to be owned by an LLC, partnership, most types of trusts, another corporation, or non-U.S. citizen/resident. If you want to have these types of shareholders, filing an LLC may be right for you. S-corporations are the best choice for those that wish to retain unlimited flexibility with regards to scaling their management– as long as you do not mind limiting the number of investors to 100.
5. 100% of Your Business Profits Go to Earnings
If you usually pass all of your business profits through to earnings anyways, an S corporation is right for you. S corporations are not the appropriate corporate entity choice when you expect to use your yearly earnings for expansion or if you need to retain those earnings for capital reinvestment. If you aim to reinvest your earnings or aim to earn a significant portion of your income passively, you might not want to file as an S corporation and a C corporation may be more appropriate for you.
As the top personal income tax rate is now higher than the top corporate tax rate, you may wish to file as a C-corporation to retain some or all of your business’ earnings rather than passing the entire amount through (as with S corporation and LLCs) in order to create the lowest possible tax liability for you and your business.
S corporations are particularly vulnerable to large tax bills on large appreciating investments. If you plan on selling assets and experience capital gains on those assets, you may be better off with an LLC or a sole proprietorship.
How Does an S Corporation Compare to Other Corporate Structures?
Your company’s S corporation status will be revoked if your company generates greater than 25% of its income from “passive activities” for three consecutive years. The IRS defines “passive activities” as business relations where you do not actively, materially, and regularly participate in the business matter. For instance, if your business has a few rental properties, they would need to generate income less than 25% of your total income for at least one year every three years so the IRS does not reclassify your business as a C-corporation. If you do or plan to generate more than 25% of your income passively, then an S corporation is not the best choice for you and an LLC may be more beneficial.
LLCs have drawbacks of their own, however. S corporations have what is known as “perpetual existence,” whereas LLCs typically exist only for a limited time. Additionally, S corporation stock is freely transferable while LLC ownership stakes are not. If you or your investors want to sell some or all of your LLC ownership stake, you must first obtain the approval of all the other LLC shareholders. In contrast, S corporation shareholders are able to sell their S corporation stock whenever they please.
S corporation shareholders are also taxed proportionally to the number of shares they own. For instance, if you own 70% of the stock, then you must receive 70% of all profits, losses, deductions, and credits. When comparing an S corporation to an LLC or partnership, the LLCs and partnerships are a bit more flexible when it comes to earnings and distribution. For instance, a partnership agreement can detail the differing percentages allocated to each partner. These percentages can even change over time. An LLC can allocate percentages in an identical manner, allocating 15% to one partner for the first three years of the operation, then 25% afterward.
The Internal Revenue Code is the definitive guide for S corporations, defining the rules for filing, dissolving, electing members, and financial distributions. S Corporations, for instance, do not allow for any differentiation in the issuance of stock: all stock must be identical–with the important exception of voting power. If you want more differentiation, you are better off with a C corporation as your corporate structure. There can be no “second class” of stocks in S-corporations like there commonly is with C-corporations. The only allowable difference between shares of S-corporation stock is that some shares may retain voting rights while others may be issued specifically without voting rights.
If you want a more traditional corporate structure and see the need to reinvest the earnings or have large passive income flows, then a C corporation might be the most appropriate corporate structure for you.
Is an S Corporation Right for You?
There are several reasons why forming an S corporation is the best choice for your business entity. An S corp allows you to protect your personal assets from exposure to your small business entity. You can enjoy many benefits of a C-corporation while avoiding double-taxation on company earnings (as long as earnings aren’t reinvested). If you generate little-to-no business taxable income from passive activities or appreciating investments, then an S corporation may be right for you.
S corporations give you the freedom to appoint an unlimited number of managers, eliminates the state residency restriction with regards to members, and allows for up to 100 total members–so long as they are eligible individuals, families, estates, or other special trust entities.
The “S” in S corporation stands for “small business corporation,” a federal distinction obtained by filing Form 2553 (Election by a Small Business Corporation) of Chapter “S” in the federal Internal Revenue Code. You form your corporation under state law, incorporating in a particular state (it doesn’t need to be the state where you reside), and then, by through your S-corporation filing, you eliminate corporate-level federal taxation while preserving the corporation’s limited liability.
If you want your S corp status to take effect quickly, it’s important to understand that you only have 2 months and 15 days from the beginning of the tax year to take your election into effect and file your Form 2553. If you want your S corp status to be effective next year, you can simply file Form 2553 anytime in the preceding tax year.
Be wary, though: S-corporation requirements can be tricky to navigate. For instance, S-corporation elections are known to be fragile (all shareholders must agree to the election), and the paperwork associated with the regular S corporation filings can be tedious, onerous, and often perplexing. A few simple mistakes can cause your company to lose its S corporation status and risk your company being taxed as a C corporation. It’s always wise to consult with a tax expert and legal advisor to ensure you are making the best decisions for your business. For assistance forming an S corporation and minimizing your tax liability, reach out to the experts at Anderson Advisors today.