What are the Advantages of an S Corporation: Everything You Need to Know
What are the advantages of an S corporation? This is a common question on the mind of many business owners. It is important to know about the various types of business structures to choose from, one of them being the subchapter S corporation.3 min read
What are the advantages of an S corporation? This is a common question on the mind of many business owners. It is important to know about the various types of business structures to choose from, one of them being the subchapter S corporation.
An S corporation is a special election made after incorporating your business. It must be made through a formal request with the IRS. Be mindful that the S corp is not its own business structure. Rather, it is a corporation that shares many formalities of the typical C corporation, but has some unique differences, particularly in terms of tax treatment. The S corp is treated as a pass-through tax entity; because of this, the profits of the business are filed on the owners’ personal tax returns.
While the biggest difference is in the tax treatment, the S corp still shares the same corporate formalities as the C corp, including the fact that the S corp must hold meetings and record meeting minutes. Furthermore, the S corp is owned by shareholders who hire a board of directors to oversee the management of the business. In turn, the directors hire officers to handle the daily operations of the corporation. The S corp shareholders have the same limited liability protection as C corporation owners, as well as LLC owners.
Advantages of an S Corp
There are several advantages to operating an S corp, including the following:
- Limited liability protection
- Pass-through taxation
- Tax-favorable income
- Simple ownership transfer
- Cash method of accounting
- Enhanced credibility
- Payroll tax savings
As previously noted, the S corp shareholders cannot be held personally liable for the debts or liabilities of the corporation. Therefore, if a creditor or third party brings a lawsuit against the corporation, the shareholder's personal assets are protected, even if the corporation is held liable and the property belonging to the corporation doesn’t satisfy the full debt.
Pass-through taxation is one of the biggest advantages of operating an S corp. Since the S corp doesn’t pay corporate income tax, the company files Form 1120S with the IRS indicating the portion that all shareholders will report on their personal tax returns. Their portion will include the businesses profits, losses, expenses, and credits.
S corp shareholders who are also employees of the business can receive a reasonable salary from the corporation. Therefore, they cannot simply receive dividends as compensation. While dividends aren’t taxed, the compensation is in fact taxed. Therefore, while you might think of this as an advantage in order to receive tax-free dividends, you still must ensure that you are paid a reasonable salary, which will be subject to self-employment, Social Security, and Medicare tax.
Unlike an LLC, the ownership in an S corp is simple. In fact, a shareholder in any corporation (C or S corp) can freely transfer his or her shares to another. No adjustments need to be made to the property basis; furthermore, transferring one’s shares doesn’t automatically terminate the corporation, as could be the case in an LLC.
Most C corps must abide by the accrual method of accounting, which might not be favorable to smaller businesses. Therefore, if you operate an S corp with no inventory, you can utilize the cash method of accounting, particularly if you have gross receipts of $5 million or less. If, however, you have inventory, then you must still use the accrual method.
Operating as an S corp can help establish credibility with potential customers, vendors, suppliers, and financial lending companies. This is because you have formally incorporated your business, as opposed to simply operating as a DBA or conducting business on your own with no formal business name attached to your work.
S corporations are a great choice for businesses that want to provide some sort of service to the general public, whether it be medical, dental, legal, or consultant services. Furthermore, the S corp is good for new businesses that don’t have the capital or funding to expense the formation costs associated with forming and operating a C corp. If a newly formed business doesn’t need to make large equipment purchases before operating, then the S corp is a good choice.
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