There is a lot of confusion and misinformation on the internet about S-Corporations, so today I’m taking a few minutes to clear up this confusion and discuss the advantages, disadvantages, and eligibility requirements of an S-Corp election.
What is an S-Corp?
An S-Corporation is a small business corporation. The S-Corp election allows the owner(s)/shareholder(s) to only be taxed at the individual level instead of at both the corporate and individual level. We’ll go over an example of this below.
Advantages of an S-Corp
- The big advantage of the S-Corp status is a tax concept called pass-through taxation. Pass-through taxation means that your company isn’t taxed on the income it generates. Instead, this income can be distributed to the owner(s)/shareholder(s).
- Another important advantage is the limited liability protection for owners and shareholders. There is an extra layer of security for your personal assets in the event your company is dissolved or is being sued.
- Your company can attract investors through the sale of shares of stock, giving you investment opportunities for the continued growth of your business.
- Your business will continue to exist even if the owner leaves, retires, or dies.
Disadvantages of an S-Corp
- There is additional paperwork and fees involved. It is necessary to incorporate the business by filing Articles of Incorporation with your state, obtain a registered agent for your company, and pay the appropriate fees. Many states also impose ongoing fees, such as annual report or franchise tax fees. These fees are typically minimal and in most cases you will recoup the amount you paid in fees with tax savings.
- Because the S-Corp status allows for distributions to a shareholder, the IRS scrutinizes payments to make sure the characterization conforms to reality.
- If the company tax status is compromised by either non-resident stockholder or stock being placed in corporate entity name, the IRS will revoke the status, charge back-taxes for 3 years, and impose a further 5-year waiting period to regain the tax status.
What is pass-through taxation?
Here is an example of how pass-through taxation works for an S-Corp:
Sarah is the owner of a graphic design business which generates $100,000 in profit. Sarah formed an LLC to operate her graphic design business, and she has elected to have it taxed as an S Corporation. Sarah is an employee of the LLC and receives a $40,000 salary. The remaining $60,000 of the business’s profits are passed through the S corporation and reported as S corporation profit on Sarah’s personal income tax return, not as employee salary. Because this $60,000 profit is not viewed as employee wages, neither Sarah nor her company need to pay Social Security or Medicare tax on this amount. Sarah and her corporation only pay a total of $6,120 in employment taxes (15.3% x $40,000 = $6,120). Then, Sarah just has to pay income tax on the S-corporation profit of $60,000. Had Sarah not elected S corporation status for her LLC, she would have had to pay self-employment tax and income tax on this entire $100,000 profit. This would have required her to pay an additional $9,180 in Social Security and Medicare tax.
When should your business become an S-Corp?
Every business that files for corporation status is first classified as a C Corp or single-member LLC. Once that’s complete, you have to elect to the subchapter S corp status and meet all requirements for an S-Corp.
Answer the questions below to determine if you qualify for the S-Corp election:
- No, your company is not eligible for the S-Corp election.
- +Your company must be registered as a corporation with your state before you qualify for the S-Corp status.
- +Your company must have less than 100 shareholders.
- +All of your shareholders/owners must be U.S. citizens.
- +All of your shareholders must agree and sign off on the S-Corp election.
- +You must pay the shareholder/employees a reasonable salary for their position.
- +If your company is a publicly held company, you can only have one class of stock.
What is a reasonable compensation for an S-Corp?
There are several factors to take into account when determining a reasonable compensation for an owner/shareholder.
- The employee’s qualifications.
- The nature, extent, and scope of the employee’s work.
- The size and complexity of the business.
- A comparison of salaries paid with the gross income and net income of the business.
- The prevailing general economic conditions.
- A comparison of salaries with distributions (or dividends) to stockholders.
- The prevailing rates of compensation for comparable positions.
- The salary policy of the taxpayer to all employees.
- The amount of compensation paid to a particular employee in previous years.
This can be a quite the undertaking when operating a small business, which is why I always recommend completing the S-Corporation Reasonable Compensation Report. This report synthesizes a proprietary blend of IRS criteria, court rulings, geographic data and a database of wages to accurately assess reasonable compensation for S-Corp and small business owners.
How do I apply for S-Corp status?
- Choose and reserve a legal name. Many states allow you to reserve a legal name with the Secretary of State.
- Draft and file an Articles of Incorporation.
- Prepare the corporate bylaws to summarize company rules surrounding operations, officer positions and duties. Keep corporate minutes of all board and shareholders meetings.
- Issue stock certificates to the initial shareholders.
- Apply for an Employer Identification Number (EIN) by preparing and submitting an IRS Form SS-4.
- Depending on what type of corporation you are starting, you may need both state and local permits to operate legally. File the IRS form 2553 within 75 days of your corporation formation.
I’ve assisted many small business owners across the United States in achieving an S-Corp status, and I’d love to assist you as well. Please feel free to contact me if you’re looking for some expert help on making the switch.