When growing a business, you’ll need to figure out how to formally structure your business for tax and legal purposes. Incorporating as an S Corporation may be an attractive option for small businesses with only a few owners.

However, before committing to that structure, business owners should familiarize themselves with S Corporations.

  • What does it mean to form an S Corp?
  • Are there any requirements for incorporating as the entity?
  • What are the advantages and disadvantages of an S Corp?

Then, business owners may determine whether an S Corp is best for their business.

What Is An S Corporation?

An S Corporation is an entity that opts to be taxed under the provisions of Chapter 1, Subchapter S of the U.S. Internal Revenue Code. That means, in practice, that the company itself will not pay any income taxes. Income, deductions, credits, and losses will “pass through” to the owners. The owners will be responsible for reporting the taxable activity of the company on their personal income tax returns. However, the S Corporation structure still limits the personal liability of shareholders. Their personal assets cannot be used to cover debts incurred by the business.

How can you find out if forming an S Corporation would be a beneficial move for your business? Take a moment to review the requirements to qualify for S Corp status. Then, you may also review the advantages and potential drawbacks associated with forming an S Corporation.

Forming An S Corporation

Before you start running a cost/benefit analysis on the possible outcomes of electing an S Corp, you need to make sure that your business meets the necessary eligibility criteria. Follow this brief checklist.

Ownership Criteria

  • Business may not have more than 100 shareholders
  • Shareholders are all individual persons (some exceptions may apply)
  • No shareholders are nonresident aliens

Stock Criteria

  • Business has only a single class of stock

First, the business must incorporate or form a limited liability company (LLC). The company must also designate a registered agent service before it may apply for S Corporation status. Your business must meet the above criteria to elect an S Corporation. Then, you must file Form 2553 (“Election by a Small Business Corporation”) and have it signed by all shareholders for the IRS.

If an S corporation no longer meets the requirements to qualify (for example, if there are more than 100 shareholders), it reverts to C corporation status.

S Corporation Benefits

The primary benefit of an S corporation is that it enables the owners to legally avoid double taxation. When business income passes through to the shareholders, income taxes are only paid by those individuals. The business itself pays no corporate income taxes.

Here are a few additional advantages of filing for S Corporation status:

Pass-Through Taxes

There’s no double taxation of the business and its shareholders when you elect an S Corp status. All income tax liabilities pass on through to the individual owners. These owners must claim the income and losses from the business on their personal tax returns. Most state-level taxing authorities recognize S Corporations and allow them to file their state income taxes in the same manner. What happens when an S Corp has business losses? The owners may claim them on their taxes to reduce the amount they’re obligated to pay. This can be beneficial in the startup phase of a business, when losses often outpace revenues.

Asset Protection

If a business has S Corporation status, the entity protects assets of its shareholders with liability protection. This means their personal assets cannot be pursued by creditors to pay back debts owed by the business.

Liability Reduction

Shareholders of an S Corporation are permitted to serve as employees of the business. As a result, they receive a salary, dividends, and additional compensation. This helps reduce self-employment tax liabilities.

Simplified Transfers Of Ownership

An S Corporation can be sold as-is without incurring any new tax liabilities. Partnerships and limited liability companies may be subject to restructuring if more than 50% of their interest is transferred. 

There are other upsides to choosing an S Corporation. You may also use a cash-based accounting system. This is typically off-limits to incorporated businesses, who must use the accrual-based system. An S Corporation may also be perceived as credible to customers and vendors than another entity, like a sole proprietorship.

However, not every aspect of electing an S Corporation is beneficial. Watch out for these disadvantages before making the decision to file.

S Corporation Disadvantages

Limited Stock Options

Having an S Corporation means that you can only issue a single class of stock. While voting and non-voting stock are not considered to be “different” classes in this context, you cannot issue stock that confers different dividend or distribution rights.

Investor Restrictions

In order to retain S Corporation status, your business cannot have more than 100 shareholders. Additionally, these shareholders cannot be business entities or non-resident aliens. This may make your business less appealing to potential investors.

Ongoing Expenses And Obligations

In addition to the initial costs of incorporating the business to make it eligible for S corporation status, you must pay annual reporting and franchise tax fees imposed by the state in which you’ve incorporated. S Corporations are also required to hold annual meetings and maintain minutes.

Should You Form An S Corporation?

The choice of whether or not to form an S Corporation may depend on your formation objectives. For entrepreneurs who want to limit their tax liabilities while retaining asset protection, electing an S corporation can make a lot of sense. However, this is provided the owners don’t exceed the shareholder limits. Businesses that seek to propel their growth by attracting outside investors may find themselves hamstrung by S Corporation restrictions.

However, businesses that intend to maintain a consistent ownership structure may find many good reasons to forming an S Corporation. If you’re not sure whether an S Corporation is the right entity for you, consider seeking advice from qualified legal professionals.

Morgan Taylor is a marketing professional with a passion for banking and personal finance. As CFO for his own business, as well as CMO at LetMeBank and CFO at Jolly Content, he leverages financial experience to drive leads for his organizations as well as personal clients.

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