Deciding how to structure your business is one of the most important decisions a new business owner will make. Before choosing, it is important to consider the unique features of all business structures. One popular choice particularly among small and mid-sized businesses is the S Corporation. S Corporations (S Corps) offer certain tax benefits that can be more advantageous than a traditional C Corporation structure. Limited Liability Companies further have the flexible option to elect whether to be taxed as either an S Corp or a C Corp. Having a good understanding of the unique S Corp rules is essential. Here are five key things you need to know about S Corps as you weigh your choices:
- Pass-Through Taxation: One of the most significant advantages of an S Corporation is the so-called “pass-through” tax treatment under federal tax law. In a traditional C Corporation, the corporation itself is taxed on its profits. Shareholders are then further taxed on the dividends that they receive. For small businesses, this taxation at both the corporate and shareholder levels can be costly. S Corps avoid this as a pass-through entity. “Pass-through entity” simply means that the profits and losses of the business are reported on the individual tax returns of the company’s shareholders. As a result, S Corp shareholders can avoid the so-called double taxation at the corporate level and again at the shareholder level.
- Limited Liability Protection: Like C Corporations, S Corps continue to offer limited liability protection to its owners. This means that the personal assets of shareholders are protected from the debts and liabilities of the corporation in most instances.
- Ownership Restrictions: S Corps have strict ownership restrictions that could make it unfeasible for certain businesses. For example, S Corps cannot have more than 100 shareholders. All shareholders must further be U.S. citizens (or resident aliens). Additionally, an S Corp cannot be owned by another business entity, such as corporations, LLCs, partnerships, or certain types of trusts. These restrictions on ownership mean that an S Corp structure may not be the right choice for every business.
- Eligibility Requirements: To qualify as an S Corp, a business must meet certain IRS eligibility requirements. The S Corp must be a domestic corporation, have a single class of stock, and meet the ownership requirements discussed in detail above.
- Shareholder Compensation: In an S Corp, employees who are also shareholders are required to receive reasonable compensation for services rendered to the corporation, subject to payroll taxes for costs such as Social Security and Medicare. Those profits that are distributed as dividends, however, are not subject to self-employment taxes. Depending on the financial situation of the company, this distinction allows S Corporation shareholders to potentially reduce their tax liability by structuring their compensation as a combination of salary and dividends.
By understanding the key defining features and considerations of S Corps, business owners can make informed decisions that align with their long-term goals and objectives. Contact the attorneys at Way Law to discuss whether an S Corp may be the right choice for your business!