S Corp Tax Benefits: Everything You Need to Know
S corp tax benefits are the tax advantages of forming a subchapter S corporation. 3 min read
S corp tax benefits are the tax advantages of forming a subchapter S corporation. This business entity is a corporation that is treated as a pass-through entity by the IRS. This means that the corporation can avoid double taxation since each shareholder reports profits and losses on his or her individual tax return.
To create an S corporation, you must file Articles of Incorporation with the secretary of the state where you plan to establish your business. Like a C corporation, an S corporation must have directors, shareholders, officers, and issue stock. The owners of an S corporation also enjoy limited liability protection. This means their personal assets cannot be seized to satisfy business debts and obligations.
Unlike a C corporation, an S corporation is taxed like a sole proprietorship or partnership. This avoids taxation at both the corporate level and again at the shareholder level. Instead, profits are taxed ones at the individual tax rate rather than at the higher corporate tax rate.
Is an S Corporation Right for Your Business?
When you're starting a business or considering a new entity for an existing business, considering an S corporation requires examination of tax issues, the number of shareholders, and the level of personal asset protection you desire. An S corporation, along with C corporations and limited liability companies (LLC), is one of the most popular business entities for small business owners.
Establishing an S corporation makes a big impact on how you pay taxes, handle profits, and distribute earnings to shareholders. It's important to understand the pros and cons of each type of business entity to determine which is the best choice for your situation.
An S corporation carries specific ownership restrictions for shareholders as follows:
- It can only have 100 or fewer shareholders.
- Shareholders must be individuals or living trusts.
- Shareholders cannot be non-U.S. residents, multi-member LLCs, or corporations.
S corporations that do not follow these regulations will lose their favorable tax status and be subject to double taxation.
In most cases, those who have a sole proprietorship or general partnership should consider switching to an entity that offers limited liability, such as an S corporation. This will prevent you from losing personal assets if your business is in debt or sued.
S corporations are often a good choice for service-oriented businesses, such as consulting firms. If these types of businesses do not opt for an S corporation, they will be automatically be classified by the IRS as a personal service corporation (PSC). Although C corporations are taxed at a rate of 15 percent for the first $50,000 earned, the PSC tax rate is 35 percent. In most cases, you can save money on taxes in this situation by establishing an S corporation, though your CPA or tax attorney can advise you on the potential ramifications of each business entity.
What Are the Advantages of Establishing an S Corporation?
In many cases, the advantages of establishing an S corporation are greater than the disadvantages, especially when it comes time to close the business or transfer its ownership. Advantages of S corporations that do not apply to general partnerships and sole proprietorships include:
- Protection for each shareholder's personal assets, which means his or her home, vehicle, bank accounts, and other property cannot be seized to pay a business debt or obligation unless he or she has provided a personal guarantee for a specific debt. In contrast, the personal assets of owners of sole proprietorships and general partnerships are vulnerable to business obligations.
- Pass-through taxation, in which S corporations are not subject to federal corporate income taxes or in most cases to state corporate income taxes. In contrast, C corporation profit is taxed at the corporate level when it is earned and at the personal level when it is distributed to shareholders.
- Shareholders of the S corporation can draw employee salaries as well as receive both dividends and tax-free distributions. This allows an owner who also operates the company to reduce their self-employment tax due while also providing wage deductions for the business.
- Ownership interests in an S corporation can be freely transferred without adverse tax consequences.
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