Like LLCs and partnerships, S corporations are taxed as pass-through entities. This means that S corps do not pay federal taxes on their business income. Instead, the profits of the business “pass-through” to the owners of the S corp, who are also known as shareholders. Then, the shareholders pay income tax and report their share of the profits in the form of salaries on their individual tax returns, which are then taxed.
Owners of an S corp that play an active role must become employees and be paid a “reasonable” salary (earned income) based on their position and industry. This earned income is subject to both personal income tax and employment tax, while the remaining business profits are only subject to personal income tax. After all distributions are allocated and properly taxed, these remaining business profits are then known as “retained earnings.”
Unlike standard C corporations, S corporations are not “double-taxed.” This is a major advantage of the S corp tax status. Not only do C corps need to pay federal income taxes on all profits, but shareholders also have to pay an income tax on the dividends they receive from the company.
An S corp is a pass-through tax designation that can be chosen by an LLC or a standard corporation. Each option has its own advantages. In this section, we discuss the pros and cons of forming an S corp as a corporation or as an LLC.
S Corp Status For LLCs
LLCs are great for small business owners because they combine personal asset protection with a simple and flexible business structure.
Unlike corporations, LLCs do not require a board of directors, annual board meetings, or carefully kept meeting minutes. Instead, LLCs can be formed by a single owner or by multiple partners, and the entire business can be run according to the desires of the owners.
When an LLC elects the S corp tax status, it retains this simple and flexible business structure. Therefore, forming an S corp as an LLC is great for small business owners who simply wish to take advantage of some of the tax benefits of the S corp designation.
However, if your business ever plans to get significant funding from outside investors, it is better to form a corporation. This is because the pass-through tax status of the LLC is not conducive to working with investors.
Learn more about why investors prefer to work with corporations.
S Corp Status For Corporations
Forming a corporation is often the standard option for entrepreneurs who wish to seek funding from outside investors. The fixed business structure of the corporation, with its board of directors, executives, annual meetings, etc. is something most investors are used to dealing with.
Starting out your business as an S corp may make sense if you plan to transition to C corp status when your company grows large enough to attract investors. The initial S corp status will offer certain tax benefits, and it is very easy to make the switch to a C corp down the road once your business is ready to partner with outside investors.
Here are the specific requirements for S corp election:
- No more than 100 shareholders.
- All shareholders must be private individuals. Shareholders cannot be other business entities.
- Shareholders cannot be non-resident aliens.
- The business can only issue one class of stock.
If all of these conditions are met, then your business can choose S corp status.
The S corp tax designation offers businesses some distinct advantages. This section discusses the potential ways your business might benefit as an S corp, as well as some of the drawbacks of the S corp status.
Dual Employee And Shareholders Status
Unlike other pass-through entities, the S corp owner is also considered an employee of the company, as long as they have an active role in the day-to-day operations of the business.
This can be a significant advantage for S corp owners. With the S corp status, certain business owners can save thousands of dollars in employment taxes. Consider the following example:
Maxine has an accounting business that operates as a single-member LLC, and she decides to be taxed as an S corp. Last year, Maxine’s business earned $125,000 in profits. As an employee, Maxine paid herself a reasonable annual salary of $75,000. The remaining $50,000 Maxine took as a distribution from her business. Because distributions are not subject to employment taxes, Maxine saved $7,650 in Social Security and Medicaid tax.
Note: The IRS is very strict about S corp owners paying themselves a reasonable employee salary. Make sure you can justify your salary, and that it reflects what other people in your position might be paid if they were not the business owner.
Easy Transition To C-Corp
If your business ever plans to seek outside funding from investors in the future, an S corp can be a good option to start with; this is because it is an easy process to form a corporation, elect S corp status, and then transition to C corp status later on.
Investors are used to working with C corporations for a number of reasons. C corporations have a standard business structure that investors are comfortable with, including board members, annual meetings, and detailed meeting minutes.
C corps also make tax reporting easy for investors, whereas the “pass-through” taxation of other business entities, like S corps and LLCs, can complicate the tax reporting process for passive members and investors.
Disadvantages Of The S Corp Tax Designation
One disadvantage of the S corp status is that it limits the number of shareholders your business can have. If you plan to attract investors early on in your business, it probably makes the most sense to start as a C corporation.
Another disadvantage of the S corp is that passive income distributed to members are taxed at the higher dividend rate, which is the same rate as ordinary income tax. C corp shareholders, on the other hand, may be eligible for the significantly reduced tax rate of qualified dividends.
Should I Elect S Corp Status?
There are two ways to form an S corp: (1) as an LLC, and (2) as a corporation.
Electing S Corp Status As An LLC
It is easy to elect S corp status once you have formed an LLC. All you need to do is file Form 2553 with the IRS.
We offer a comprehensive guide to form an LLC in all fifty states. Simply select your state below to get started:
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Electing An S Corp As a Corporation
Here are the steps to forming an S corp as a corporation:
- Choose a name for your corporation
- Appoint a registered agent
- File your Articles of Incorporation
- Obtain an Employer Identification Number (EIN)
- Meet with directors and establish bylaws
- Start a corporate records book
For detailed information on starting a corporation, check out these guides compiled by our friends at Startup Savant.