Whether you are just starting your new business, or you have been operating as a sole proprietorship or general partnership for years, you may be wondering about the advantages of operating your business as an S Corporation. Many business owners mistakenly assume that switching over to an S Corporation will be too costly or time-consuming, but with the right advice, making your business into an S Corporation can be a profitable enterprise. Operating as an S Corporation has many advantages, especially when it comes to taxes and business growth. They are of course not without their disadvantages. The issue is in figuring out if the pros outweigh the cons.
This post will explore the advantages and disadvantages of the S Corporation and maybe help determine if operating an S Corporation is the right move for your small business.
What is an S Corporation?
An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election. S Corps elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
What is needed to create an S Corp?
A corporation must meet certain conditions to be eligible for a subchapter S election. First, the corporation must have no more than 100 shareholders. In calculating the 100-shareholder limit, a husband and wife count as one shareholder. Also, only the following entities may be shareholders: individuals, estates, certain trusts, certain partnerships, tax-exempt charitable organizations, and other S Corps (but only if the other S Corp is the sole shareholder).
In addition, owners of S Corps who don’t have inventory can use the cash method of accounting, which is simpler than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid.
Why you should consider an S Corporation for your business
The S Corp presents unique advantages that can make them a smart choice for a growing business. Let’s have a look at some of those features.
One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all. Many business owners choose S Corporations over C Corporations for the benefit of avoiding double taxation. With a C Corporation, shareholders are taxed on their profits. Since a typical owner of a C Corporation takes salary or distributions from the profits, they are taxed twice…Once for the profits of the company, and again for the salary or distributions.
An S Corporation protects the personal assets of its shareholders. When an express personal guarantee is absent, a shareholder is not personally responsible for the business debts and liabilities of the corporation. Creditors cannot pursue the personal assets, such as a house, bank accounts, cars, etc. of the shareholders to pay business debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same, which leaves personal assets vulnerable.
If your S Corp experienced a net loss for the fiscal year, that loss flows through to your personal return. That loss then reduces the amount of taxes you owe on your personal return. Conversely, with a C Corporation, profits are taxed but the losses are not deductible on your personal return. Of course, losses can be applied to future years’ earnings, assuming the C Corporation experiences profits during those future years. In practice however, many new C Corporation businesses usually lose money for the first few years, hence neutralizing whatever advantage the C Corporation model might present to your small business. Needless to say, the ability to deduct the losses from your personal taxes is a great benefit for you and your small business.
Transferring of ownership
What about your financial interests in your S Corp? Those interests can be freely transferred without triggering adverse tax consequences. A partnership or LLC by contrast, has no such advantage. In a partnership or LLC, the transfer of more than a 50-percent of the interest in the entity can trigger the termination of the entity. S Corporations don’t need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.An S Corp designation allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S Corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business, this improves the protection of the shareholders.
Insurance for the Shareholders
Shareholders or executives who own more than 2 percent of the company’s stock may have their health insurance, health savings accounts and premiums deducted from the revenue of the company before taxes. These amounts have to be included as part of the taxable income of the officers of the company. This reduces the total amount of gains and increases the total amount of losses. What does this mean for the shareholders? Those losses will flow through to the personal tax return of those shareholders.
Credibility can be everything when starting a new business -choosing to operate as an S Corp, rather than as a sole proprietorship or general partnership, signals a level of professionalism and a formal commitment to the business. The formal appearance of an S Corporation can help a new business establish credibility with potential customers, professional staff, vendors and partners; they see the owners have taken the next step with their business. This can encourage investment opportunities and help your new business grow.
So what’s the downside?
As with any business model, there are risks and costs to consider. There are some primary disadvantages with an S Corporation business model. Let’s explore those now.
Start-up & Expenses
The first step in running an S Corp is the initial incorporation. This means filing Articles of Incorporation with the Secretary of State of California, obtaining a registered agent for your company, and of course, paying the appropriate fees associated with all of the above.
If you want to start your business out of state, some states impose ongoing fees, such as annual report and/or franchise tax fees. These fees are usually not cost prohibitive, and they can even be deducted as a cost of doing business, but they are expenses that a sole proprietor or general partnership will never have to pay; just another calculation that your business should consider.
Got to follow the Corporate Model
S Corps must follow all of the formal legal procedures that all types of corporations must follow. S Corps must hold annual shareholder meetings to elect members to the board of directors, as well as report all profits and losses on their federal and state tax returns. S Corps will also require significantly more paperwork associated with their tax filings than similar business entities like LLCs or general partnerships and so of course, will have higher tax preparation costs.
S Corps also must pay a franchise tax of 1.5% of net income in the state of California (a minimum of $800). This is one factor to be taken into consideration when choosing between a limited liability company and an S Corp in California. For highly profitable enterprises, the LLC franchise tax fees (minimum $800), which are based on gross revenues, may be lower than the 1.5% net income tax. Conversely, for high-gross-revenue, low-profit-margin businesses, the LLC franchise tax fees may exceed the S Corp net income tax.
Allocating Income and Loss Problems
Corporations can issue stock. C Corporations can have more than one class of stock. An S Corp may only have one class of stock. What this means in a practical sense is an S Corp cannot easily allocate losses or income to specific shareholders. Income and loss allocation is governed by stock ownership. So the more stock you own in your S Corp the greater the income and loss allocation. By contrast in a partnership or LLC the allocation of income and loss can quite conveniently be set in the business’s operating agreement. It is also worth mentioning that an S Corp will require an accumulated adjustment account. Those can be tedious to maintain and require the assistance of an accounting professional.
An S Corporation is a valuable option for many businesses due to the tax incentives it presents and the opportunities for garnering investment to help grow your business. Of course this business model does not work for everyone. A small business owner would be well advised to consult a professional before committing to any new business entity.
If you are interested in forming your own S Corp for your small business, or learning more about S Corporations in California, and how they may affect you, then please contact Larry Horwitz at email@example.com.