S Corporation Liability: Everything You Need to Know
S corporation liability protection is one of the reasons S corporations are popular among business owners.3 min read
S corporation liability protection is one of the reasons S corporations are popular among business owners. It also has significant tax advantages. To be considered an S corporation, an election is made with the IRS, and the S corporation is then treated as a pass-through entity for federal taxation purposes.
Pass-through taxation eliminates the double taxation of C corporations, only taxing shareholders on their personal returns rather than on both the corporate and individual level. S corporations do not pay taxes at the corporate level.
To create an S corporation, you must file articles of incorporation with the Secretary of State where you will operate the business. S corporations can issue stock, and like C corporations, they are run by directors, officers, and shareholders. These shareholders enjoy the same liability protections as C corporation shareholders. Their personal assets, however, cannot be used to settle business debts.
Advantages of an S Corporation
Many business owners choose to form an S corporation for the advantages it offers, such as:
- S corporations protect the shareholders' personal assets; shareholders are not responsible for the corporation's legal liabilities and business debts. Creditors cannot seize their personal assets to satisfy company debts. This is different from a sole proprietorship or a partnership, in which the owner and business are one and the same.
- S corporations do not pay corporate income tax. Most states also do not collect tax from S corporations. Income and loss pass through to shareholders, who report it on their personal tax returns. This allows shareholders to offset income with business losses.
- S corporations can consider shareholders employees and pay them salaries. Shareholders also receive distributions in the form of dividends, which are taxed at a lower rate. As long as this is done reasonably in accordance with IRS rules, it can significantly reduce the amount of taxes shareholders owe.
- Because an S corporation issues shares of stock, the ownership interests can be transferred to new owners easily. In an LLC or a partnership, transferring more than 50 percent of ownership interest can force the company's dissolution.
- Corporations are required to use the accrual method of accounting unless they have an income of $5,000,000 or less. S corporations can use the cash method unless they have inventory to report.
- Potential business partners, employees, vendors, customers, and financial organizations might view S corporations as more credible than other partnerships. This is because the owners have formally committed to their business.
Disadvantages of an S Corporation
Although there are many reasons to form an S corporation, be aware of the disadvantages, as well:
- S corporations have significant formation expenses and ongoing fees. These fees might include annual report fees or franchise taxes, but are not typically large amounts of money. Sole proprietorships and partnerships do not pay these fees.
- If an S corporation makes mistakes regarding stock ownership, filing requirements, consent, or notification, it might be terminated. However, this is usually easy to fix.
- An S corporation must use the calendar year as its tax year unless it can prove a business-related reason for having a different fiscal year.
- S corporations can only issue one class of stock. They can, however, issue shares that allow voting and those that do not. This makes it less attractive to investors, who might want different dividends or distribution rights.
- S corporations can't have more than 100 shareholders.
- Shareholders in an S corporation cannot be foreign investors, certain kinds of trusts, or other corporations.
- The IRS often watches S corporations closely because of their profit distribution methods. The IRS wants to make sure a corporation does not count an unreasonable amount of income as dividends rather than wages.
- Because an S corporation can only issue one class of stock, all profits and losses must be distributed equally to all shareholders. In a partnership or an LLC, this is flexible.
Reporting Requirements for S Corporations
If an S corporation is not set up properly, its owners can be sued.
S corporations must obey all corporation laws in the state in which it is formed to retain its limited liability protection. You can hire an attorney to avoid this. Because you are still responsible for compliance, make sure this attorney is reliable and experienced in corporate law.
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