Why S Corp?: Everything You Need to Know
An S corp designation can be elected through the IRS to access pass-through taxation, in which income is only taxed at the individual level.3 min read
Why S corp is a question that must be considered by business owners who are considering incorporation or who already have a C corporation or LLC and want to access the tax benefits of an S corporation. An S corporation designation can be elected through the Internal Revenue Service (IRS) to access pass-through taxation, in which income is only taxed at the individual level and not at the corporate level.
Like other corporations, an S corporation is established by submitting articles of incorporation to the Secretary of State where your business is located. This type of corporation may issue stock and is governed in the same way as a standard C corporation, with shareholders, officers, and directors.
Many business owners prefer an S corp over a C corp because C corporations are subject to double taxation. C corporations and limited liability companies (LLC) are also popular business entity choices. A corporation that opts for S corp taxation can revert to a C corporation in the future.
While an S corp can own an LLC, only single-member LLCs can own S corp shares. Opting for S corp status also avoids classification as a personal service corporation (PSC) by the IRS, a designation for consulting firms and other service providers that can carry a heavy tax burden.
Most businesses find that S corp status has more advantages than disadvantages. These include:
- Personal asset protection for shareholders, unlike a general partnership or sole proprietorship in which business debts can be satisfied with the seizure of personal assets. The only exception to this protection is when a shareholder is negligent or has personally guaranteed a business loan.
- Pass-through taxation at the federal level as well as at the state level in many instances. Most states automatically accept the federal S corp designation.
- The ability for shareholder-employees to draw a salary from the business to reduce self-employment tax liability while generating corporate deductions. In addition to their salaries, shareholders can also receive tax-free distributions as well as dividends.
- Share transfer without negative tax consequences.
- Use of the simple cash method of accounting, while C corporations must use the more complicated accrual method unless that have gross receipts of less than $5 million. The exception is S corporations that have inventory, which must use the accrual method.
- Increased credibility with existing and potential employees, customers, partners, and vendors
- Continued existence even when an owner leaves or dies, unlike an LLC which is dissolved in those circumstances.
- Annual tax filing instead of quarterly as required for a C corporation
S Corporation Disadvantages
Potential negative aspects of an S corporation include the following:
- You will be subject to formation costs and ongoing fees, which vary by state. These may include but are not limited to the fee for filing articles of incorporation, registered agent fees, annual reporting fees, and franchise tax fees. These expenses are not applicable to a general partnership or sole proprietorship.
- Failure to meet requirements for consent, election, notification, filing, and stock ownership can result in loss of S corp status, which will leave you vulnerable to double taxation.
- S corps must operate on the calendar year unless they have a specific business reason why a fiscal year is necessary.
- Only one class of stock may be issued, and the S corp can only have 100 shareholders. However, voting and non-voting classes can be established. Shares cannot be owned by other entities, foreign individuals, and certain types of trusts.
- S corps are typically scrutinized more closely by the IRS than other business entities are. The agency may re-characterize wages as dividends, which means they cannot be deducted. If S corp status is revoked, you will owe three years of corporate back taxes and cannot regain this status for five years.
- S corps have less allocation flexibility when it comes to income and loss than other corporations do because of the one stock class rule.
- No more than 25 percent of gross receipts can come from passive income, including investment in real estate.
If you need help with deciding whether an S corporation or another entity is the right choice for your business, 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.