Understanding the S Corp
One of the biggest misconceptions when choosing a business model is that an S Corp. (short for “small corporation”) is among one of the options. In fact, you cannot choose to form your business as an S Corp., but you can elect for S Corp. tax treatment by the IRS once you’ve already formed your business entity. This is true regardless of whether the company formed as an LLC or a corporation because an “S Corp.” merely describes how the IRS taxes the business. We know, it’s a deceiving title, right?
Since an “S Corp.” merely describes how the IRS will tax your business, you’re best off consulting with your accountant on whether or not S Corp. election makes sense for your business needs. In the meantime, we’ve provided you with some basic information on S Corp. elections below.
1. What are the primary benefits of S Corp. election?
Shareholders primarily benefit from the S Corp. model because they do not pay taxes on distributions. Furthermore, any retained income of an S Corp. increases the tax basis of its shares, which allows its shareholders to avoid capital gains taxes on any stock appreciation upon a sale.
2. How does S Corp. status affect my corporation?
Typically, the IRS taxes regular corporations twice. Once at the corporate level and again at the shareholder level. But for an S Corp., the IRS only taxes its income once—at the shareholder/owner level, so the corporation’s income, losses, and tax credits “pass-through” to its owners.
3. Can I elect S Corp. treatment for my LLC?
Yes. From a legal standpoint, the company will remain an LLC when it elects S Corp. status. This means the business still gets all the advantages of the LLC in terms of fewer filings with the state, as well as less paperwork and lower costs all around. But from the perspective of the IRS, the business will be taxed as an S Corp. Therefore, it gets the pass-through of income just like a sole proprietorship or partnership, plus the added flexibility of distributing some of the business’s income as distributions, not salary. Thus, an LLC can elect for S Corp. status and benefit from its taxation scheme.
4. How does an LLC differ from a corporation with S Corp. status?
Before the LLC business model was created, the only way owners could limit their personal liability was by forming a corporation, and the only way they could avoid double taxation was by making an S Corp. election. Today, however, many owners looking for limited liability and a “pass-through” entity select the LLC model because they are not bound by the many regulations that still burden regular corporations. For instance, LLCs require less state filings, lower start-up costs, no formal meetings, and less paperwork as compared to corporations. That’s usually a big advantage for small business owners who don’t want to be burdened by corporate formalities and more paperwork. Additionally, the LLC offers more flexibility in how owners can allocate the percentage of profits and losses among the owners.
A multi-owner LLC is automatically taxed as a partnership by default, while LLCs with one owner are taxed like sole proprietorships (single owner businesses). The S Corp. election gives you more flexibility on how earnings are paid to the owners. For example, with an LLC, the entire net earnings are passed along to the owners in the form of self-employment income. Therefore, they are subject to self-employment tax for social security and Medicare. With the S Corp. election, you have the option of dividing up earnings into wages/salaries and then passive income in the form of distributions. Only the wages/salaries are subject to the FICA tax for social security and Medicare. The distributions are not. However, keep in mind that the owners working in the business must pay themselves reasonable salaries for their positions.
5. What are the requirements for S Corp. election?
Your company can file for S Corp. election with the IRS as long as its shareholders consent to the election, the corporation was formed in the United States, has only one class of stock, with no more than 100 allowable shareholders.
- The Corporate Form: Lots to Choose From
- Should Your New Business be an LLC or a Corporation?
- The Rise of Hybrid Organizations
Disclaimer: Although this article may be considered advertising under applicable law and ethical rules, the information in this article is presented for informational purposes only. Nothing herein should be taken as legal advice and this content does not form an attorney-client relationship. If you would like further information, Wilkinson Mazzeo would love to hear from you, so please feel free to reach out with any questions!
Photo credit: Phillip Harder