S Corp limitations do exist, despite the many benefits an S structure gives to business owners.

An S Corp is not a separate corporation, but a separate tax code within a corporate entity. With that, all corporations are not eligible to choose an S status. As an owner, you must be aware of all options to save your business money so that you have additional capital to invest in your business. Such a classification allows shareholders to include a piece of the S Corp income on individual tax returns, as prescribed by the share amount that he or she owns in the business.

An S Corp may be taxed as a partnership, also called a disregarded entity, which provides shareholders certain tax privileges in return for various operation limits. Such a tax method will reduce the overall tax balance paid on business income. In return for such a right, an S Corp needs to adhere to certain restrictions, and some restrictions may determine how a business operates.

Incorporation Basics

The incorporation process creates a distinct business entity that gives shareholders certain liability protections. With that, a corporation can fall into an S Corp or C Corp; in essence, an S Corp is a C Corp with certain distinctions. Such differences pertain to who may be a shareholder and how the shareholders and business pay taxes on losses and profits. The business issues stock and is managed like a corporation in the form of:

  • Directors
  • Officers
  • Shareholders

Members of a corporation have the same rights and protections as a C Corp, and the owner (or shareholders) have the same protections as C Corp shareholders. The S Corp protects a shareholder’s assets, such as:

  • Personal bank accounts
  • Cars
  • Houses
  • Boats

Pass-Through Taxation

However, as is the case with a partnership or sole proprietorship, S Corp uses what’s called pass-through taxation, where profits and losses pass from the business to individual shareholders. Such losses and profits can then be recorded on their personal tax returns. S Corps differ from C Corps because they are not directly taxed. S Corp shareholders only pay taxes upon filing their personal tax returns. On the other hand, C Corps face a double tax: one tax on the business and another when shareholders file their tax returns. S Corps get around double taxation because members only have to pay taxes owed on their tax returns.

S Corp Benefits

S Corps benefits businesses in the following ways:

  • Provides a great business model for businesses in the service industry (i.e., consultants)
  • Does not require heavy start-up capital
  • Great for businesses that do not need to purchase major equipment before starting the business
  • Businesses that will make a great deal of money without extensive expense and effort

Such advantages are usually unavailable to other entities, such as general partnerships and sole proprietorships. Other S Corp advantages entail:

  • Asset Protections: S Corps protect all personal assets of shareholders. Creditors may not petition for assets to satisfy business obligations. This is not the case with general partnerships or sole proprietorships, and all personal assets are subject to creditor petitions.
  • Special Tax Characteristics: S Corps shareholders may be classified as employees of the business, giving them special tax savings. They can take employee salaries while getting dividends from the business, including additional distributions that are tax-free relative to their share in the business. Further, distribution characterizations help owner-operators lower self-employment taxes and can still generate wages-paid and business-expense deductions from the company.

S Corp Drawback

All shareholders who work as employees should be paid a reasonable amount of compensation, and such a salary is open to Medicare and Social Security taxes that need to be half-paid by the employee and the other half by the business. Therefore, the self-employment tax savings only go into effect when the S Corp earns enough to the point where lingering profits exists.

Ownership Transfer

When it comes to ownership transfer, the interests within an S Corp may be freely transferred without tax ramifications. In addition, an S Corp does not have to make any adjustments to property basis or adhere to accounting rules upon ownership transfer.

If you need help learning more about forming an S Corp and the other benefits of operating an S Corp, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.