Choosing a legal structure for your business is not something you should do on a whim. How you organize, pay taxes, and the legal liability exposure of your business all depends on how you form your company. Each business structure has its advantages and disadvantages.
For companies seeking the most liability protection, incorporating a C Corp or a limited liability company (LLC) shields the owners and shareholders from the debts and liabilities of the corporation. The company lives as a separate entity, and the owners’/shareholders’ personal assets are protected from business-related risks.
Businesses looking to grow and entice investors typically incorporate to benefit from the liability protections a corporation offers. However, many owners find the tax requirements too much of a burden. To alleviate some of the burden, many business owners elect S Corporation (S Corp) status—a choice that can profoundly affect their taxes, liability, and overall business strategy.
What is an S Corporation?
The deadline to file for S Corporation status is March 15. Even though that date has passed, it’s smart to learn about the advantages of becoming an S Corp for future considerations.
An S Corp is a tax designation allowing qualifying small businesses to avoid the double taxation assigned to C Corps. Instead of taxing the corporation as a separate entity, profits and losses are passed through to shareholders and reported on their individual tax returns. Pass-through taxation can lead to significant tax savings for business owners.
Not every business can elect S Corp status. For one, the company must be incorporated with the state and comply with all the requirements set forth by the Secretary of State.
As far as the Internal Revenue Service (IRS) is concerned, the corporation:
- Must be filed as a US corporation
- Can maintain only one class of stock
- Is limited to 100 shareholders or less
- Shareholders must be individuals, estates, or certain qualified trusts
- Requires each shareholder to consent in writing to the S Corporation election
- Requires each shareholder to have a U.S. Social Security Number
- Requires each shareholder to be a U.S. citizen or permanent resident alien with a valid United States Social Security Number
- Must have a tax year ending on December 31
When Does an S Corp Election Make Sense?
Typically, business owners consider an S Corp election when the company becomes consistently profitable. S Corp status is particularly beneficial when the business generates enough income to justify the potential tax savings. Plus, S Corps maintain limited liability protections, operational flexibility, and employee benefits. Let’s start with the tax advantages.
1. Tax Advantages
One primary reason businesses elect S Corp status is the tax benefits it offers. S Corps benefit from pass-through taxation, meaning business profits are not subject to corporate income tax. Instead, they are passed through to shareholders and taxed at individual tax rates, which can result in significant tax savings, especially for businesses with relatively few shareholders.
Also, by structuring compensation as a combination of reasonable wages and dividends, S Corps can reduce the overall payroll tax burden. Shareholders/employees may take advantage of the tax savings associated with dividend distributions, which are not subject to payroll taxes, while still receiving compensation for their services.
2. Limited Liability Protection
S Corps also offer limited liability protection to their shareholders. As previously noted, shareholders are typically not personally liable for the corporation’s debts and obligations, shielding their personal assets from business-related liabilities—a benefit for owners and an enticement for investors.
3. Operational Flexibility
Electing S Corp status can also provide operational flexibility for small businesses. Unlike C Corps, which are subject to certain restrictions on ownership and corporate formalities, S Corps have fewer regulatory obligations. Fewer compliance requirements are attractive for entrepreneurs seeking to streamline administrative processes and focus on growing their businesses.
4. Employee Benefits
S Corporations can offer attractive benefits to employees and enjoy the tax benefits available to corporations, which is an increased tax advantage. Benefits such as health insurance, retirement plans, and stock options also help attract and retain top talent.
Critical Considerations Before Electing S Corporation Status
While S Corps have many advantages, there are several potential downsides to the S Corp election.
Before electing S Corp status, make sure your business meets the IRS’s eligibility requirements. Failure to meet these requirements could result in penalties or loss of S Corp status.
Also, while S Corps offer tax advantages, they have specific tax implications that must be considered. For example, shareholders must report their share of profits and losses on their individual tax returns, which could affect their overall tax liability.
S Corp shareholders must receive reasonable compensation for their services, including salaries, bonuses, or other forms of compensation. Failing to pay adequate compensation could raise red flags with the IRS and jeopardize your S Corp status.
Finally, although S Corps have fewer regulatory requirements than C Corps, they still need to adhere to certain corporate formalities, such as holding regular shareholder meetings and keeping accurate financial records.
Becoming an S Corp
Even though the S Corporation election deadline has passed, you can still file for S Corp status at any time during the year. If you choose to do so, your company will be taxed under your old status for part of the year and as an S Corp for the rest. You will have to prepare two separate sets of tax forms.
If you’re planning ahead and know you want to apply for S Corp status for next year, you can file Form 2553 with the IRS anytime this year.
Startup business owners who plan to launch their companies later this year have two months and 15 days from their date of formation or incorporation to file for S Corporation status for this year.
Electing S Corp status can be a strategic move for small businesses looking to maximize their potential. S Corps offers compelling benefits for eligible companies, including tax advantages, limited liability protection, and operational flexibility. Before electing S Corp status, discussing your options with your accountant and attorney is crucial to ensure you’re well informed and make the best decision for you and your company.
CorpNet offers business formations, filings, state tax registrations, and corporate compliance services in all 50 states. Express and 24 hour rush filing services available upon request. Click here to learn more.
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