In this post, we explain what an S Corp is and the pro and cons of registering a business as an S Corporation.
If you want to keep your business running, it means controlling expenses even more than making profits. This is why many new business owners are looking for ways to save money, especially when it comes to their tax status.
Understanding what is an S Corp and just as importantly, knowing the pros and cons of an S Corp will help you in making the right decision about whether to form one as part of your business.
What follows is an explanation, the structure, and the advantages along with the disadvantages of whether creating an S Corp is right for your needs.
What is an S Corp?
An S Corporation is also known as a Subchapter S Corporation or a Small Business Corporation. This means that it is a corporation that holds a special federal tax status. Keep in mind that an S Corp is not a business entity, but rather a tax designation status at the federal level.
The result is that the IRS allows the corporations to let their income, deductions, and credits go through the shareholders. Put simply, those who are the shareholders of the company shoulder the burden by paying taxes on the income they receive through the company itself.
They add this income to their own and file it as part of their tax return for their personal income. The practicality of the S Corp becomes apparent when the shareholders are not subject to double taxation. Double taxation occurs when the company has to pay its taxes, and then the shareholders pay more in taxes from the profits earned through the company.
So, in bypassing the company, the taxation at the federal level only applies to the personal income of the shareholders themselves.
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How to Obtain S Corp Status
To gain the S Corp tax status, the company must become a corporation first. This means you have to structure the company as a C corporation. In other words, you have to make a typical corporation, as found in the US. A C Corporation is formed through the state and not at the federal level, so you will need to check with your state rules and regulations about becoming this type of corporation.
There is another path in which you can file for an S Corp status if your company is an LLC or Limited Liability Company. This means that your business will have to fill out the procedures to become an LLC and meet the criteria set by the IRS to gain S Corp tax status.
Qualifying for S Corp is fairly straightforward. You must first meet the requirements that enables your company to become a C corporation or LLC and then obtain the following;
- Based in the US
- Cannot be a Bank, Insurance Company, or Domestic International Sales Corporation
- Allowable Shareholders: No partnerships, non-US citizens, or other corporations
- Limit of 100 shareholders
- One Type of Stock: It cannot have preferred or two-tiered system of stocks
All shareholders must agree to create the S Corp status as it will appear as part of their personal income. Once this is completed, you can take the next step if you desire. Just keep in mind that if your company does not meet one or more of the criteria that it will need to be addressed before you can go any further. You will need to consider if the effort is worth the potential gains.
File Form 2553
Form 2553 is the Election by a Small Business Corporation, which all shareholders must sign. It is a tax form that has four separate parts.
- Name, Address, State & Date of Incorporation
- Employer ID Number
- Tax Year Information to Obtain S Corp status
Also, all shareholders must submit their name, signature, address, social security numbers, and a number of shares that are being held.
QSST: Election Under Section 1361(d)(2)
This is part of the trusts that apply to gain S Corp status. All the names, addresses, and social security numbers of beneficiaries must be submitted at this time. It includes the name, address, and employer ID number of the trust as well.
If you are filing after the deadline for that particular year, you will need to file Form 2553 no later than two months, and 15 days after the start of the tax year, the election will take place. Otherwise, you will have to wait until the following year. In most years, the deadline is March 15th.
If you have created an LLC, then you will need to file Form 8832. Either way, you are now ready to get your S Corp status. But the bigger question is whether you should become an S Corp or not. There are advantages and disadvantages that you need to consider before taking the next step.
Pros and Cons of an S Corp
There are plenty of reasons why becoming an S Corp is advantageous to you and your fellow shareholders.
Save on Taxes: Arguably, the best reason is to avoid having double taxation. This means that instead of paying the corporate tax and then paying it again through your individual return, you only pay for the individual returns. This means that as an S Corp, you are only paying employment taxes such as Social Security and Medicare for the wages you pay for your employees.
All other income goes to the shareholders through the distribution of the profits your company makes. Such distributions are not subject to the self-employment tax. Basically, many business owners would enjoy having S Corp status because they pay considerably less overall in terms of the total taxes being paid.
There is one caveat in that you are required to pay a “reasonable salary” to your employees, which includes yourself. What defines a reasonable salary is not exact, at least according to the IRS.
Still, you should pay yourself the same way as similar companies would be based on the position, experience, and size of the company. Just be sure that whatever salary you decide, it holds up to any potential IRS audit.
Lower Tax Payment: When it comes to selling your business, you’ll pay considerably less in taxes if you are an S Corp compared to a standard C Corp.
While the advantages are substantial, there are some issues that you will need to contemplate before getting an S Corp status for your taxes.
Requirements: The IRS has strict requirements for the operation of an S Corp. Any variation or failing to meet such standards may result in the revocation of the status and reverting to a C Corp. That means you may pay considerably more in taxes.
The most common cause for revocation is a company that expands beyond the 100-shareholder limit. If you are operating a business that is growing rapidly to the point where you can see surpassing that limit, then you should not apply for S Corp status.
Reasonable Salary: As mentioned before, if the IRS does not find the salary of the corporate officers reasonable, then they may revoke the status. This also applies if you have not correctly reported the wages, especially if it decreases the burden of the taxes. This may result in a high penalty for what is not reported.
The state in which you live may affect whether an S Corp is right for you. This is because S Corps are treated differently depending on the state government in terms of taxes. So, what might be beneficial in one state may not be so in another. This means that while you might gain benefits in terms of your federal taxes, you may pay more in state taxes.
In any event, you should consult with a professional tax accountant, law firm, or team that can provide you with the best answers. You will need to take everything under consideration if you are going to try for S Corp status.
While there is no single answer for everyone, it can be said that small business owners who plan on either keeping their company small or selling it before they reach 100 shareholders should seriously consider an S Corp.
Conversely, those who plan on growing a company rapidly and stick with it, especially if you are near the 100 shareholders level probably should not consider going with an S Corp.
You may pay more in taxes as a result, but if you are going to exceed the restrictions anyway, then it is not worth it. Plus, you will not have to fret about what a “reasonable salary” is for the corporate executives.
Knowing what is an S Corp, along with understanding the pros and cons of an S Corp, means you have the knowledge to make the right decision about whether to form one. This is a decision that should not be taken lightly as an S Corp is well designed for certain businesses while not suitable for others.
Do your research, consult with experts, and make the best-informed decision about whether an S Corp is right for you.