We will take a close look at the drawbacks and S corporation advantages, also known as S corps.
S corps offer limited liability and simple tax treatment. They're pass-through entities which means the profits of the business pass through to the owners personal tax returns.
Before the advent of LLCs, using an S corp was the main way a business owner could limit his liability and also enjoy similar pass-through tax treatment to partnerships and sole proprietorships.
Many tax pros and attorneys argue that LLCs have largely replaced S corps because they offer they same liability protection and tax treatment but are easier to run.
Setting Up Your S Corporation
Like LLCs, when you set up any corporation you have to pay state filing fees. These vary from state to state but are typically between $100 and $300. In some states it's cheaper to set up an LLC and in others it's cheaper to set up a corporation. However, the cost difference is rarely big enough to influence your choice of business structure.
For example in California the state filing fee for an LLC is $70, for a corporation it's $115. In Texas the filing fee for an LLC is $325 and $332 for a corporation.
There are plenty of online firms like mycorporation.com which will set up your corporation for just a few hundred dollars.
So what's the difference between setting up an S corporation and a C corporation? An S corp is just a corporation that has filled in IRS Form 2553 electing for pass-through S Corp Tax treatment. Hence the legal and other costs of setting up an S corporation are similar to those of a C corporation. Online incorporation services usually charge less than $100 to complete Form 2553 for you.
Once the S corp election is made it continues until you stop it. You do this by sending a letter to the IRS. However, you have to be careful because, once revoked, S corporation status cannot be claimed again for another 5 years.
Tax Treatment of S Corporations - S Corp Tax
S corporations are ?pass-through? entities because the profits pass through the business and onto the owner's personal tax return. The business is not taxed separately.
This means they're taxed in pretty much the same way as sole proprietorships and partnerships.
In fact the only business that is taxed separately is the C corporation. As we'll see shortly, C corp profits are taxed at corporate income tax rates.
Remember LLCs don't have their own set of tax rules. You can decide for yourself if you want your LLC be taxed like a sole proprietor/partnership, S corporation (S Corp Tax) or C corporation.
So this section on the tax treatment of S corporations is important for LLC owners as well because many do, in fact, think about electing S corp tax treatment.
Even though S corps are pass-through entities they do have to file a special tax return ? Form 1120S ? reporting the profits or loss of the business. K-1 forms are then given to the shareholders who report their share of the income on their individual tax returns.
Many businesses start life as an S corp because any losses can flow through to your individual tax return and can offset other income. When they become more profitable they sometimes convert to C corporations to benefit from income splitting and fringe benefits.
There are several decisions to consider when forming a business entity; it is important to be familiar with the tax ramifications of a given business entity before it is filed with the designated state agency. Forming an S-Corporation is one of several options when deciding which type of business entity to form; other options include the LLC and C-Corporation. There are several practical and legal concerns to take under consideration as you determine how to structure your business. You must establish whether or not your company will go public, you also need to consider the number of partners or shareholders within the company, and, perhaps most importantly, explore all the tax ramifications of each business entity. With all these considerations in mind, there are some distinct advantages to choosing the S-Corporation as your business entity.
One advantage of the S-Corporation is that like the LLC it receives pass through taxation. Pass through taxation simply means that federal income tax is not assessed at the entity level; profits are distributed in the form of dividends and flow through to the individual tax returns of the shareholders, and the IRS taxes the shareholders at their individual income tax rate and not at the entity or corporation level. Therefore the S-Corporation, unlike the C-Corporation, is not subject to double taxation. Since net losses are ?passed through? as well, the individual shareholder may be able to reduce his or her tax liability by offsetting other income with any S-Corporation losses. One of the most enticing advantages of the S-Corporation is its ability to minimize payroll / self employment taxes which can be a significant amount of money, currently the rate is set at 15.3%. For example let's take an S-Corporation with a single shareholder, if the company was to have a net profit of $90,000.00 and the shareholder employee assigned himself a salary of $25,000.00 he would be able to reduce payroll / self employment taxes by $9,945.00. This is because only the $25,000.00 salary portion would be classified as earned income and subject to payroll / self employment taxes, the remaining $65,000.00 would pass through as a non-qualified dividend. While taxed at the personal income tax rate of the shareholder, the $65,000.00 is exempt from the self-employment / payroll taxes.
Companies doing business as an LLC have the same advantage of pass through taxation; however a single member LLC is treated as a disregarded entity by the IRS. The business entity is disregarded as a separate entity from its owner for Federal tax purposes; essentially what this means is that the IRS classifies the single member LLC as a sole proprietorship and since all income from a sole proprietorship is treated as earned income the full $90,000.00 would be subject to the 15.3% payroll / self employment tax. For this reason, an S-Corporation could be viewed as a superior entity choice for the individual owner who is looking to minimize his or her payroll and self-employment tax exposure.
A multimember LLC is treated by the IRS as a Partnership as the default status for federal tax purposes. This requires that the LLC file the Form 1065 Partnership return (informational only ? the LLC does not pay federal taxes), and the net income (or loss) passes through and is accounted for on the tax returns of each individual member.
Companies doing business as S-Corporation must first form a standard corporation with the state (and the default federal tax status at that point is that of a C-Corporation). After the corporation is formed with the state the company must file an IRS Small Business Tax Election form 2553 stating their intention to be taxed as an S-Corporation. IncFile prepares the Form 2553 and returns it to you for your signature along with your filed corporation, and after the initial shareholders have signed it can simply be faxed or mailed in to the IRS. The IRS Form 2553 must be signed and submitted to the IRS within 75 days of the date of formation of the corporation.
Both Nick Braun Ea Phd & Grojan Fabiola are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
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