When you hear the word corporation, you probably think of a large Fortune 500 company. And while many of those businesses are indeed incorporated, not every corporation needs to be a large business. In fact, any small business owner—even a sole proprietor—can turn their business operations into an S-corp.
S Corporation Advantages
- Limited Personal Liability
- Perpetual Existence
- Better Fringe Benefits
- Pass Through Taxation
- Easy Transfer of Ownership
The S corporation derives its name from Subchapter S of the Internal Revenue Code. The key quality of such a corporation is that it can pass profits, losses, credits, and deductions onto the individual tax returns of its shareholders—in other words, its owners. This helps the corporation avoid paying corporate tax, the tax rate of which has been at 21 percent since the Tax Cuts and Jobs Act was implemented, but may increase to 28 percent if political winds shift.
In addition to the tax benefit of avoiding a more punitive tax rate, the S corp designation provides businesses owners with risk reduction by separating personal and business assets, along with several other benefits we will outline below.
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How to Qualify as an S Corp
There are a few qualifications a business or sole proprietor must meet in order to be classified as an S corp. It must be located within the United States. If it issues stock (which is probably not applicable to most small business owners), it must only issue one class of stock. It cannot have more than 100 shareholders, and those shareholders must be individuals, trusts, estates, and tax-exempt corporations like the 501(c)(3)—no partnerships, and no alien residents. If all those qualifications are met, all shareholders must sign IRS Form 2553, Election by a Small Business Corporation, along with filing articles of incorporation with the secretary of state in the state in which they reside.
Other forms will be needed at the outset of the corporation, as well as on a periodic basis, so it’s good to consult with a lawyer or tax advisor about what those are in your specific state.
Top 6 Advantages to forming an S Corporation
There are many benefits to structuring your business as an S corporation, including:
1. Limited Personal Liability
Much like the similar business entity formation of the limited liability corporation (LLC), an S-corporation provides shareholders with limited liability protection. In addition to the fact that each shareholders’ assets are separate from the company—thus rendering them impervious to a lawsuit—creditors cannot seek to satisfy their debts to the company by pursuing the assets of a shareholder, nor can they seek to satisfy the debt obligation of one shareholder in default by pursuing the assets of another shareholder.
2. Perpetual Existence
As long as the corporation remains up to date with all its requisite forms and filings, the corporation can exist into perpetuity. This is especially advantageous in the event that there are multiple shareholders and one passes away unexpectedly.
3. Better Fringe Benefits
There are several other benefits to forming an S corporation that are not readily apparent at first glance. One such benefit is that an S-corp is able to use the cash method of accounting instead of the accrual method of accounting, with certain exceptions.
To keep things simple, the cash method focuses more on the present and actualized profits and losses, while the accrual method is forward-thinking, requiring invoices and future payments to be taken into account. This makes the cash method of accounting simpler and can help a business avoid the need to pay extra small business taxes that could impede cash flow.
4. Pass Through Taxation
The pass through taxation of an S-corp is perhaps its greatest benefit, helping small business owners avoid paying more taxes than they can afford.
As mentioned, the S-corp is not taxed like an actual corporation with profits hit at a 21 percent tax rate. Rather, profits and losses are passed on to the shareholders and treated as earned income, for which they pay income tax at whatever tax bracket they are in.
The catch is that shareholders who are actively involved in the business must put themselves on a payroll and pay FICA taxes on those W2 wages. However, with the right numbers in place, this can be beneficial to the shareholders and result in paying less taxes than they would if they worked as an employee, filed as a sole proprietor, or had their profits taxed at the corporate tax rate.
At Anderson Advisors we have a team of attorneys that are dedicated to making certain you have the right business structure in place. When it comes to an S corporation, we are experts at making certain that you pay the least amount of taxes based on the profits of your company. Call us today for your free strategy session and see what we can do for you.
5. Easy Transfer of Ownership
When looking at the formation of an S corp, one can see that it facilitates an easy transfer of ownership. By contrast, when an LLC or partnership sees a transfer of ownership, it can trigger accounting issues or even terminate the entity entirely.
The exact ins and outs of this may vary from state to state, so it’s good to discuss the S corp election status with an attorney or tax advisor if you believe that there may be some transfer of ownership in your business at any point, whether it’s with you or one of the other shareholders.
You can easily do this with one of our business structure advisors by scheduling a consultation for a free entity formation blueprint.
The final benefit of forming an S-corp may come as a surprise, since it relates more to marketing than paying taxes or avoiding liability.
Incorporation shows customers, clients, employees, vendors, and partners that you are serious about your business, and that you are willing to put in the time, money, and paperwork to make it official. You may not think this matters much, but when dealing with customers and business vendors, it can be a make it or break a deal—people prefer to structure deals with credible and stable entities.
Should Your Small Business Become an S Corporation?
In many cases, even if your business is run as a sole proprietorship, it could benefit from being structured as an S corporation. Keep in mind that corporations must adhere to certain rules and formalities, like paying estimated quarterly taxes, creating articles of incorporation, and having a board of directors (even if it’s just you). It may be tempting avoid following the elements that seem like mere customs, but in rare instances it can result in piercing the corporate veil—a legal situation where a judge will rule that that the corporation is merely a formality set up to obfuscate unethical behavior, and render the shareholders or owners subject to personal liability at the hands of creditors or plaintiffs seeking damages.
If you don’t mind filling out the requisite paperwork or paying an accountant to do it for you, the S corp structure can yield some serious tax savings while also affording the same liability protection as the LLC. If for whatever reason, however, you will not be able to keep up on this paperwork or appoint someone to do it, an LLC might be a better option.
Another consideration is the type of business that you run. If you and several other professionals have banded together to form a practice in a field like financial services, accounting, law, medicine, or engineering, an LLP (limited liability partnership) may be better.
But in most cases, electing to be taxed as an S corp is going to save you money if you are self employed, invest, or run a business. That’s because an S corp helps you avoid certain forms of taxation that most employed individuals take for granted.
Does an S corp help you avoid paying taxes?
There is a bit of a misconception out there that S corp taxation is all about circumventing the Internal Revenue Service for tax purposes, something that cannot be achieved with a limited liability company. An S corp is not going to help you avoid paying personal income tax, though. It can, however, impactfully reduce your tax liability. This is because every S corporation shareholder can be placed on a payroll, even if the S-corp only has one person. Doing this helps the salary recipient avoid the onerous 15 percent self employment tax that would need to be paid on business income if they did not set up an S-corp.
This 15 percent tax is normally split between an employer and the employee, with the taxes going towards programs like Social Security and Medicare. However, as a self-employed individual or investor writes their own paycheck, they have to shoulder the entirety of that 15 percent, which can be burdensome. Moreover, keep in mind that this FICA tax or payroll tax comes out of the paycheck before the recipient files income taxes on their take home pay.
By putting yourself on the S corporation’s payroll, you will only pay FICA tax on that amount. It does need to be a reasonable salary for your profession, otherwise it will raise a red flag to the IRS and they will dissolve the S-corp or pursue other measures, such as fines, fees, and back taxes. The remainder of the business income will pass through to your personal tax return and will be taxed at your personal tax bracket, which is probably lower than the corporate tax rate.
At the end of the day, S corp shareholders avoid double taxation on their earned income from business activity. They avoid paying corporate taxes, and they avoid paying FICA taxes on the entirety of their earnings.
S Corporations Offer Tax and Liability Advantages to Small Business Owners
Each and every individual shareholder will see a great benefit in terms of the tax advantages on their personal tax return when they structure their business structure as an S corporation. This is because their personal income avoids corporate income tax, and a sizable portion of it can avoid FICA tax as well.
In addition to the tax advantages, it also affords a great measure of liability and risk reduction for the S corp owner and other shareholders. Then of course, there is also the increase in credibility that comes with structuring the activity that generates your income as a corporation on paper.
You can learn more about this seemingly complicated but very beneficial method of paying less on your federal income tax as a business owner, investor, or self-employed individual in our How to Structure a Business Workshop. Don’t put your company’s success off any longer—sign up today!
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