S corporations are a great choice for many small businesses. But what exactly are they, and why should you consider one?
One type of business structure that is especially good for small businesses is the S corporation, which is also called a Subchapter S corporation. It combines the limited liability protection of a traditional corporation with the tax advantages of a partnership. This means owners, called shareholders, are shielded from personal liability for business debts, similar to a corporation. But unlike corporations, which are taxed twice (once on corporate profits and again on dividends distributed to shareholders), S corporations avoid double taxation.
However, picking an S corporation is not always the best choice. You should carefully weigh the benefits and drawbacks to determine whether it aligns with your company’s objectives. You can decide if a S corporation is the right choice for you by learning more about the pros and cons.
Requirements to file S corporation
The corporation must meet the following conditions in order to be an S corporation:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
To become an S corporation, the corporation must submit Form 2553, Election by a Small Business Corporation, with all of its shareholders’ signatures. You can find all the information you need and find out where to file Form 2553PDF in the instructions.
Benefits of S Corporations
S corporations offer several advantages that can be attractive to small business owners. Let us look at some of the most important benefits:
Pass-Through Taxation
This is a great benefit. In traditional corporations, profits are taxed twice, once when they are given to shareholders as dividends (double taxation). S corporations do not have to deal with this double whammy. Instead, the corporation itself pays no income tax. The business’s profits and losses “pass through” the S corporation and are reported on the shareholders’ personal tax returns. This can be a significant tax advantage for owners, especially in profitable years.
Limited Liability Protection
Similar to a traditional corporation, S corporations offer limited liability protection to their shareholders. This means that the shareholders’ personal assets (homes, cars, etc.) are generally shielded from liability for business debts and lawsuits. If the company faces financial trouble, creditors can only go after the corporation’s assets, not the shareholders’ personal belongings. This provides valuable peace of mind for business owners.
Salary and Dividend Flexibility
S corporations offer owners flexibility in how they receive compensation. Owners can be paid a reasonable salary as employees, which is subject to payroll taxes. Additionally, they can also receive dividends from the corporation’s profits. This split allows for potentially lower tax burdens compared to a sole proprietorship or partnership where all income is considered self-employment income.
Attracting Investors
S corporations can issue stock to raise capital. This can be attractive to potential investors who are looking for ownership opportunities and a share in the company’s profits.
Easy Termination
Compared to traditional corporations with complex dissolution procedures, terminating S corporation status is generally simpler. This can be a benefit for businesses that may not intend to operate for the long term or have a clear exit strategy.
Drawbacks of S Corporations
While S corporations offer enticing benefits, it’s important to be aware of the potential drawbacks before making the switch. Here are some key considerations:
Strict Eligibility Requirements
Qualifying for S corporation status comes with specific limitations. The IRS imposes a cap of 100 shareholders. Additionally, S corporations can only issue one class of stock, meaning all shares must have identical rights regarding voting and profit distribution. There are also restrictions on shareholder types. Only U.S. citizens or permanent residents, certain trusts, and estates can be shareholders, limiting ownership flexibility. (Internal Revenue Service (.gov), Requirements for an S Corporation:
Increased Filing Requirements
Compared to simpler structures like sole proprietorships, S corporations face additional filing requirements. They must file separate federal income tax returns (Form 1120S) and pay federal payroll taxes. Depending on your state, there may also be additional state filings and fees. This can translate to increased administrative burdens and potentially higher accounting costs.
Potential for Payroll Taxes
The flexibility to receive both salaries and dividends can be a benefit, but it comes with a caveat. The IRS scrutinizes the reasonableness of salaries paid to S corporation shareholders who are also employees. If salaries are deemed too low compared to the value of services provided, the IRS can reclassify a portion of dividends as wages, subjecting them to payroll taxes and impacting both the corporation and the shareholder.
Limited Ownership Flexibility
As mentioned earlier, S corporations have restrictions on shareholder types. Foreign ownership is generally prohibited, and only certain types of trusts and estates can be shareholders. This can limit your options for raising capital or bringing on specific partners.
Final Thoughts on S Corporations
S corporations are one of a kind because they protect you from liability and may give you tax breaks. But the requirements for eligibility, the difficulty of filing, and the limits on ownership and profit distribution need to be carefully thought through. For businesses that qualify and prioritize tax savings, S corporations can be a powerful tool.
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- https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
- https://www.investopedia.com/terms/s/subchapters.asp
- https://www.hrblock.com/tax-center/small-business/s-corporations-partnerships/
