Why s corp

S corp shareholders can be company employees, earn salaries, and receive corporate dividends that are tax-free if the distribution does not exceed their stock basis. If dividends exceed a shareholder's stock basis, the excess is taxed as capital gains—but these are taxed at a lower rate than ordinary income.

Other advantages include being able to transfer interests or adjust property basis, without facing adverse tax consequences or having to comply with complex accounting rules.

Because S corporations can disguise salaries as corporate distributions to avoid paying payroll taxes , the IRS scrutinizes how S corporations pay their employees. An S corporation must pay reasonable salaries to shareholder-employees for services rendered before any distributions are made. When it comes to making those distributions to stakeholders, the S corp must allocate profits and losses based strictly on the percentage of ownership or number of shares each individual holds.

If an S corp doesn't—or if it makes any other noncompliance moves, like mistakes in an election, consent, notification, stock ownership, or filing requirement—the IRS could terminate its Subchapter S status. This happens rarely, though. Usually, a quick rectification of non-compliance errors can avoid any adverse consequences.

Filing under Subchapter S also requires time and money—or more precisely, the business of setting up a corporation does. The business owner must submit articles of incorporation with the Secretary of State in the state where their company is based. The corporation must obtain a registered agent for the business, and it pays other fees associated with incorporating itself.

In many states, owners pay annual report fees, a franchise tax, and other miscellaneous fees. However, the charges are typically inexpensive and may be deducted as a cost of doing business. Also, all investors receive dividend and distribution rights, regardless of whether the investors have voting rights.

Finally, there are the qualification requirements. The limits on the number and the nature of shareholders might prove onerous for a business that's growing rapidly and wants to attract venture capital or institutional investors. Tax benefits: no or lesser corporate and self-employment tax for owner, no double taxation for shareholders.

A limited liability company LLC is another type of legal business entity. Like the S Corp, it's a common go-to structure for small businesses. LLCs and S corps share other characteristics as well. However, LLCs are more flexible than S corps. They can allocate their profits and losses in whatever proportions the owners desire. Easier to establish than S corps, LLCs typically are formed by sole proprietors or small groups of professionals, like attorneys, doctors, or accountants.

However, their financing options are more limited—generally, to bank loans, as opposed to equity investors. This can limit their potential for growth. Although they are largely exempt from corporate taxes, S corporations must still report their earnings to the federal government and file tax returns.

Form S i s essentially an S corp's tax return. Often accompanied by a Schedule K-1 , which delineates the percentage of company shares owned by each individual shareholder, Form S reports the income, losses, dividends, and other distributions the corporation has passed onto its shareholders. Unlike C corps, which must file quarterly, S corps only file once a year, like individual taxpayers.

Form S is simpler than tax forms for C corporations, too. The version for ran five pages. The form is due by the 15th day of the third month after the end of its fiscal year—generally, March 15 for companies that follow a calendar year. Like individuals, S corporations can request a six-month extension to file their tax returns. S corporations can be the best of both worlds for a small business, combining the benefits of corporations with the tax advantages of partnerships.

Specifically, S corporations offer the limited liability protection of the corporate structure—meaning an owner's personal assets can't be accessed by business creditors or legal claims against the company. But, like partnerships, they don't pay corporate taxes on any earnings and income they generate. They can also help owners avoid self-employment tax, if their compensation is structured as a salary or a stock dividend.

It has elected to be taxed under this provision of the IRS code. S corps are also known as S subchapters. S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level. In order to become an S corporation, the corporation must submit Form Election by a Small Business Corporation signed by all the shareholders.

See the Instructions for Form PDF for all required information and to determine where to file the form. If you need to depart the company, having S corp status can simplify and speed up the process.

That makes it easier to sell, transfer, or grow your company. Every business structure and tax status has inherent drawbacks. Here are the main S corp disadvantages you need to be aware of:. Your business has to abide by a number of rules to maintain its S corp eligibility.

The IRS doesn't offer specific salary numbers, but you can find guidelines in Publication , under Test 1 — Reasonableness. Also, S corps must establish the calendar year as their tax year in most cases. Violate a rule, and you could quickly go from tax-exempt to double taxation. For instance, even though Texas recognizes S corp status , S corps are still charged the corporate franchise tax.

S corps have to log meeting minutes, hold bylaws, practice strict recordkeeping, and file certain federal and state reports — just like any other corporation. Business owners without finance management experience may need to hire an experienced accountant, bookkeeper, or tax professional to stay compliant.

We can break down the application process into three simple steps:. You can find complete instructions on how to form an S corporation on the IRS website. Find more information about registering your business at the local, state, and federal level on the SBA website.

Both new businesses and long-lived companies can see serious tax advantages by electing S corporation status. Pros An S corporation usually does not pay federal taxes at the corporate level. As a result, an S corporation can help the owner save money on corporate taxes. The S corporation allows the owner to report the taxes on their personal tax return, similar to an LLC or sole proprietorship. An established S corporation can help boost credibility with suppliers, investors, and customers since it shows a commitment to the company and to the shareholders.

S corporations allow the owner to benefit from personal liability protection, which prevents personal assets from being taken by creditors to satisfy a business debt. Also, employees of an S corp are also members, which means they're eligible to receive cash payments via dividends from the company's profits.

Dividends can be a great incentive for employees to work there and help the owner attract talented workers. There are also some disadvantages to establishing and operating an S Corporation. Cons Although most states allow the income generated from an S corporation to be taxed on the owner's personal tax returns, some states do not. In other words, some states choose to tax an S corporation as if it was a corporation. It's important to check with your local Secretary of State office to determine how S corporations are taxed in your state.

S corporations can incur a number of fees, including those for filing an annual report, hiring a registered agent, which handles legal matters for the business, and other fees for the Articles of Incorporation filed with the local Secretary of State office. S corporations can be more cumbersome to establish and operate than an LLC since they require a board of directors and corporate officers.

Also, filing guidelines and regulations are more rigid for S corporation vs. LLCs, including for the annual shareholder meetings, issuance of stock shares, and keeping meeting minutes. A business owner who wants to have the maximum amount of personal asset protection plans on seeking substantial investment from outsiders or envisions eventually becoming a publicly traded company and selling common stock will likely be best served by forming a C corporation and then making the S corporation tax election.

It is important to understand that the S corporation designation is merely a tax choice made to have your business taxed according to Subchapter S of Chapter 1 of the Internal Revenue Service Code.

An S corporation might begin as some other business entity, such as a sole proprietorship or an LLC. The business then elects to become an S corporation for tax purposes. A limited liability company is easier to establish and has fewer regulatory requirements than other corporations.

LLCs allow for personal liability protection, which means creditors cannot go after the owner's personal assets. An LLC allows pass-through taxation, meaning business income or losses are recorded and taxed on the owner's personal tax return.

LLCs are beneficial for sole proprietorships and partnerships. An S corporation's structure also protects business owners' personal assets from any corporate liability and passes through income, usually in the form of dividends, to avoid double corporate and personal taxation. S corporations help companies establish credibility as a corporation since they have more oversight. S corps must have a board of directors who oversee the management of the company.

However, S corps can have shareholders and pay them dividends or cash payments from the company's profits. An LLC is better for a single-owner and likely better for a partnership. An LLC is more appropriate for business owners whose primary concern is business management flexibility.

This owner wants to avoid all, but a minimum of corporate paperwork does not project a need for extensive outside investment and does not plan on taking her company public and selling the stock. In general, the smaller, simpler, and more personally managed the business is, the more appropriate the LLC structure would be for the owner.

If your business is larger and more complex, an S corporation structure would likely be more appropriate. It depends on how the business is established for tax purposes and how much profit is going to be generated.

Both an LLC and S corp can be taxed at the personal income tax level. S corporation owners must be paid a salary in which they pay Social Security and Medicare taxes. However, dividend income or some of the remaining profits after the owner's salary has been paid can be passed through to the owner, but not as an employee, meaning they won't pay Social Security and Medicare taxes on those funds. An S corporation provides limited liability protection so that personal assets cannot be taken to satisfy business debts by creditors.

S corporations also can help the owner save money on corporate taxes since it allows the owner to report the income that's passed through the business to the owner to be taxed at the personal income tax rate. If there will be multiple people involved in running the company, an S corp would be better than an LLC since there would be oversight via the board of directors.

Also, members can be employees, and an S corp allows the members to receive cash dividends from company profits, which can be a great employee perk. If you're a sole proprietor, it might be best to establish an LLC since your business assets are separated from your personal assets. You can always change the structure later or create a new company that's an S corporation. An S corporation would be better for more complex companies with many people involved since there needs to be a board of directors, a maximum of shareholders, and more regulatory requirements.

LLCs are easier and less expensive to set up and simpler to maintain and remain compliant with the applicable business laws since there are less stringent operational regulations and reporting requirements. Nonetheless, the S corporation format is preferable if the business is seeking substantial outside financing or if it will eventually issue common stock.

It is, of course, possible to change the structure of a business if the nature of the business changes to require it, but doing so often might involve incurring a tax penalty of one kind or another. Therefore, it is best if the business owner can determine the most appropriate business entity choice when first establishing the business.

In addition to the basic legal requirements for various types of business entities that are generally codified at the federal level, there are variations between state laws regarding incorporation. Therefore, it is generally considered a good idea to consult with a corporate lawyer or accountant to make an informed decision regarding what type of business entity is best suited for your specific business.