Entrepreneurs starting a small business may choose to incorporate from a wide range of business formation options. Some of these entities include forming limited liability companies (LLCs) and incorporating as corporations. Another popular option is forming an S Corporation.
S Corporations are a popular topic on our blog. Sometimes we share advice for preparing for an S Corp deadline. We also answer the question of how small businesses may elect an S Corp filing for tax purposes and save money with an S Corporation filing. However, before one can prepare for these deadlines or elect a filing, they need to know what forming an S Corporation means their business.
Let’s break down the definition of an S Corporation. After that, we will share a few benefits that come with forming an S Corporation for your business.
What’s an S Corporation?
An S Corporation is a special type of corporation. It draws its designation from Chapter 1, Subchapter S of the U.S. Internal Revenue Code. S Corporations, often abbreviated as an S Corp, are entities that choose to be taxed under this subsection.
What does this mean? A company incorporated as an S Corporation will not pay income taxes. Instead, income, deductions, credits, and losses pass through to the owners. Subsequently, the owners will be responsible for reporting the taxable activity of the company. This information is reported on their personal income tax returns.
Benefits of Forming an S Corporation
Pass through taxation is one of several benefits to forming an S Corporation. Let’s take a moment to highlight this benefit as well as a few others your business receives with this entity formation.
1. Pass Through Taxation
As mentioned above, S Corporations do not pay taxes at the corporate level. Pass through taxation allows income or losses to be reported on the business owner’s personal income taxes. As a result, S Corporations avoid the issue of double taxation.
However, there is an important caveat to consider when forming an S Corp. The owner(s) of an S Corp is an employee. This means they may draw a salary from the profits of the business. These wages are subject to self-employment taxes. Any remaining profit is distributed to the owner(s) as dividends. Dividends are taxed at a lower rate than income. That is to say, the owner(s) may potentially see a reduction in their total annual tax liability.
Therefore, shareholders that work for the company must be able to pay themselves reasonable compensation. The shareholder must be paid fair market value. Otherwise, it is possible that the IRS may reclassify any additional corporate earnings as wages.
If you’re interested in playing around with the numbers to see how forming an S Corporation may benefit you, you can try out our free S Corp tax calculator. Our tool lets you set your estimated annual income and the annual salary to estimate your potential tax savings. Just remember to pay yourself a “reasonable salary” which when working alone, should equate to approx. 50% of the total gross revenue.
2. Limited Liability Protection
Forming an S Corporation shares a similarity with entity formations like LLCs and corporations. S Corps also provide limited liability protection to small businesses.
What is limited liability protection? This is an invisible line of separation between the assets of the business and the owner(s). What if an unforeseen circumstance, such as business debt or a lawsuit, impacts the business? It would not affect the owner’s personal belongings, like their houses and cars. Limited liability protection protects these assets from seizure.
Do all business entities provide limited liability protection? Most incorporated entities do have liability protection. But sole proprietors do not have this benefit. As a result, many sole proprietors may decide to incorporate as another entity formation, like an S Corp, to ensure peace of mind in knowing they have liability protection.
3. Reduce Self Employment Tax Liabilities
Forming an S Corporation means the owner(s) are employees of the company.
Because they are considered employees, and not owners, they are able to reduce self-employment taxes that individuals within another entity formation, like an LLC, would have to pay. The salary, dividends, and additional compensation they receive help reduce self-employment tax liabilities.
4. Easy to Transfer Ownership
Let’s use an example in which you have plans to run your business for many years. However, something unexpected has come up. You need to transfer ownership of the business.
The good news is that this is easily done with an S Corp. You may transfer ownership through the sale of the company stock. S Corporations may be sold as-is without incurring new tax liabilities. This is less practical for entity formations like LLCs and partnerships. For example, if more than 50% of their interest is transferred it may be necessary to restructure both entities.
5. S Corporations are Attractive Entities
There are a few individuals for whom an S Corp has great appeal. Forming an S Corporation is a popular choice for small businesses and/or freelancers with profits between $80,000 and $100,000.
An S Corp is also appealing to bank lenders or investors. Similarly, it may improve your chance of approval for a business loan. This is because, from the perspective of an investor or lender, you have incorporated the business under an entity that creates separation between the business and its owner.
Should I Form an S Corporation?
By now you might think it’s time to start forming an S Corporation. However, it’s important to make sure that an S Corp is the right entity for your business. Consult a trusted legal professional or CPA for any additional questions you may have about S Corporations.
Once you know an S Corp is right for you, MyCorporation can guide you step by step through the filing process.
Incorporate your business today! Visit us at mycorporation.com or call us at 877-692-6772.