If you own a small business, you may want to find ways to get tax benefits. You also want to limit your personal liability. Finally, you should set your business up for long-term success. Forming an S-Corporation (S-Corp) could be a strategic choice for you.
In this guide, we will explain what this is. We will discuss its many benefits and possible drawbacks. We will also outline the steps to set one up.
We will also highlight important points for business owners in the United States. This includes corporation taxes, taxable income, and pass-through taxation.What is an S Corporation?
An S-Corp is a kind of corporation. It chooses to pass its income, losses, deductions, and credits to its shareholders for federal taxes. This allows the business to avoid double taxation, which is common in traditional C-Corporations.
With an S-Corp, business profits are not taxed at the corporate level. Instead, the income “passes through” to the individual shareholders, who report it on their personal tax returns. This pass-through taxation helps reduce the overall tax burden of business owners.
An S-Corp is distinct from other business structures such as sole proprietorships, partnerships, or C-Corporations. It combines the benefits of a corporation (liability protection) with the tax advantages of a partnership.
When is it Best to Elect to File as an S-Corp?
Deciding when to elect S-Corp status depends on the size and structure of your business. For most small business owners, the best time to make this choice is when the business starts making steady profits. If your business makes enough money, self-employment taxes can be a significant financial burden. An S-Corp can help lower those taxes.
For example, once your business generates business profits large enough to make paying self-employment taxes uncomfortable, switching to an S-Corp structure can help. In an S-Corp, the business owner can pay themselves a “reasonable salary,” and the remaining profits can be distributed as dividends, which are not subject to self-employment tax. This structure also allows for greater flexibility in tax planning, especially when considering things like passive income or businesses taxed in multiple states.
However, every business is different, and the timing of this election is crucial. Consulting with a tax professional is important to ensure that electing to file as an S-Corp makes sense for your particular situation. Keep in mind that an election to be taxed as an S-Corp must be made within a specific timeframe.
The Benefits of an S-Corp
Numerous benefits exist for forming an S-Corp, especially for small business owners who want to protect their assets and maximize tax efficiency. Below are the key benefits of choosing this structure:
1. Pass-Through Taxation
Unlike C-Corporations, an S-Corp avoids corporation taxes at the corporate level. This is perhaps the biggest benefit of electing S-Corp status. With pass-through taxation, your business income is reported on your personal tax return. The S-Corp doesn’t pay federal income taxes directly, thus eliminating the risk of double taxation.
2. Liability Protection
S-Corps provide personal liability protection for business owners. This means that the personal assets of shareholders (such as homes and savings accounts) are typically shielded from the company’s debts, legal obligations, or lawsuits. This protection is one of the primary reasons business owners choose to incorporate in the first place.
3. Self-Employment Tax Savings
Owners of S-Corps who are actively involved in the day-to-day operations of the business are required to receive a reasonable salary. However, the remaining profits can be distributed to shareholders as dividends, which are not subject to self-employment tax. This can lead to significant savings for owners, especially in comparison to the high self-employment taxes that sole proprietors or partnerships might face.
4. Credibility and Professional Image
Operating as an S-Corp can enhance your business’s credibility and professional image. The structure of an S-Corp can instill confidence in potential customers, investors, and partners. It signals that your business is a serious, established entity with defined governance, which may make it easier to secure funding or form partnerships.
5. Easier Ownership Transfers
In an S-Corp, ownership interests can typically be transferred without major tax consequences or legal complexities. This is particularly beneficial for business owners who want to bring in new partners, sell the business, or transfer ownership shares as part of a succession plan.
6. Avoidance of Corporate-Level Taxes
S-Corps do not pay corporation taxes as C-Corporations do. Instead, profits pass through to shareholders who report them on their individual tax returns. This can provide significant tax savings for small business owners.
7. State Tax Benefits
Some states offer additional tax incentives or provide lower filing requirements for S-Corporations. Depending on where your business is located, choosing an S-Corp could allow you to take advantage of state franchise tax exemptions or reduced fees. Be sure to consult with a tax professional to understand how your state taxes S-Corps.
8. Flexibility for Small Businesses
As a small business owner, an S-Corp provides several advantages over being a sole proprietor or partnership. By forming an S-Corp, you can choose your tax year (such as a calendar year) and structure the business in a way that best suits your financial goals.
The Drawbacks of an S-Corp
While the S-Corp structure provides many advantages, there are some potential downsides that business owners should be aware of.
1. Strict Eligibility Requirements
One major limitation of S-Corps is the strict eligibility requirements. S-Corps can have no more than 100 shareholders, and all shareholders must be U.S. citizens or residents. Additionally, an S-Corp can only issue one class of stock, which may limit the types of investments you can attract.
2. Limited Stock Flexibility
Unlike C-Corporations, which can issue multiple classes of stock (common and preferred), an S-Corp can only issue one class of stock. This can limit your ability to raise capital through the sale of stock or provide different types of equity to investors.
3. Administrative Burdens
S-Corps are subject to more formalities than sole proprietorships or partnerships. For example, S-Corps are required to hold regular meetings, maintain corporate minutes, and comply with ongoing filing requirements at both the state and federal levels. This requires additional administrative time and effort.
4. Reasonable Salary Requirement
S-Corps are required to pay their owner-employees a reasonable salary for the work they do in the business. The IRS closely scrutinizes whether the salary is fair, and underpaying yourself to reduce payroll taxes could lead to penalties.
How to Set Up an S-Corp
If you decide to elect S-Corp status for your business, here are the key steps to get started:
1. Choose and Register a Business Name
First, choose a name for your corporation. Ensure that the name you want is available in your state and complies with your state’s naming rules. Once you’ve decided on a name, you’ll need to register it with the appropriate state agency.
2. File Articles of Incorporation
The next step is to file Articles of Incorporation with your state’s Secretary of State office. This formal document establishes the existence of your S-Corp and includes key details about your business. You may also need to pay a filing fee, depending on your state’s requirements.
3. Obtain an Employer Identification Number (EIN)
You’ll need to apply for an Employer Identification Number (EIN) from the IRS. The EIN is used for tax filing purposes and acts as your business’s social security number.
4. Elect S-Corp Status with the IRS
To elect S-Corp status, file Form 2553, Election by a Small Business Corporation, with the IRS. You must file this form within two months and 15 days of the beginning of the tax year in which you want the S-Corp election to take effect.
5. Create Corporate Bylaws
Corporate bylaws define how the S-Corp will operate, including rules for governance, decision-making, and shareholder meetings. This step is essential for ensuring your S-Corp is compliant with both state and federal regulations.
6. Issue Stock to Shareholders
Once the S-Corp is formed, you will issue stock to your initial shareholders. This can be done in accordance with your corporate bylaws and state regulations.
7. Comply with Ongoing Requirements
S-Corps must adhere to several ongoing requirements, such as holding annual meetings, keeping corporate minutes, and filing both state and federal tax returns. Failure to comply with these rules can jeopardize your S-Corp status.
Final Thoughts
Forming an S-Corp can be a highly effective way to reduce your tax liability, protect your personal assets, and set your business up for long-term success. However, as with any business decision, there are pros and cons to consider. By staying organized, informed, and compliant with IRS regulations, you can ensure your business thrives as an S-Corp.
Need help setting up an S-Corporation we are here to help with every step? Contact RJM Tax Exemption today for expert assistance. We can guide you through every step of the process, from filing Form 2553 to ensuring compliance with all IRS regulations. If you’re looking for a comprehensive business formation package, be sure to check out our Business Formation Packages.
To get started, fill out our Information Collection Form, and we’ll help you set up your S-Corp the right way.
