You’ve probably heard that being an S Corporation has some perks. It certainly can for some businesses. Might it be the right option for you? Let’s take a moment to chat about all things S Corp so that you can gain a better understanding of what it is and its potential advantages.
First, an S Corp isn’t a type of business entity; it’s a special tax election that an eligible limited liability company (LLC) or corporation may choose. In other words, business owners must decide whether their company will form as an LLC or a corporation before they elect for S Corporation tax treatment.
The potential advantages of electing for S Corp tax treatment are a bit different for LLCs and corporations. It’s crucial to consider those differences when deciding whether it’s best to form a company as an LLC or corporation to obtain S Corporation status. It’s also critical you understand the differences between the LLC and corporation business entity types. Aside from the tax implications, there are also legal and administrative factors to consider.
Let’s step through the basics of each business structure and explore how choosing S Corporation election affects each:
Corporation Business Structure
Overview
A corporation (often called a C Corporation) is a separate legal and tax-paying entity from business owners. It exists and dies independently of its owners. This business structure provides business owners (shareholders) the highest degree of protection against any debt and legal liabilities of the company.
A C Corporation may sell shares of company stock, have an unlimited number of shareholders, and offer its employees a stock option plan.
Starting and running a Corporation
Incorporating and operating a business as a corporation is more involved and usually more costly than forming an LLC. Several of the legal steps involved include:
- Selecting a board of directors
- Drafting corporate bylaws
- Formally registering the business by filing Articles of Incorporation with the state
- Obtaining an Employer Identification Number (EIN) from the IRS
- Applying for all applicable business licenses and permits
- Issuing stock certificates
- Complying with all ongoing legal and tax requirements (such as submitting annual reports, holding board of directors meetings, holding shareholder meetings, keeping detailed meeting minutes, and more)
Default tax treatment of Corporations
A C Corporation’s profits and losses flow through to a corporate tax return. Taxable income (income after allowed business deductions) is taxed at the corporate tax rate. Note that some business income undergoes what many call “double taxation.” Business profits paid as dividends to shareholders are not tax-deductible for the business, so the corporation pays taxes on those dollars, and then the shareholders pay income tax on them, as well.
S Corporation tax treatment for Corporations
S Corp election may benefit some corporations because it allows them to avoid double taxation. With S Corporation status, the corporation’s profits and losses flow through to shareholders’ personal tax returns; the corporation itself does not pay income tax. So, the corporation’s profits are taxed at the shareholder level (according to their share of ownership) at the applicable individual tax rates. Shareholders that are also employees of the corporation only pay self-employment tax on the wages or salary that the corporation pays them. Dividend income paid to shareholders is not subject to self-employment (Medicare and Social Security taxes).