Whether you are setting up a new company or you have been in business for years, you need to evaluate which legal structure is best for your enterprise. No one option is best for every type of operation. The right choice depends on several factors, including the number of owners, taxes, and your business goals. These concerns lead many business owners to organize as S corps. The legal structure is similar to a C corporation, but the S status provides an escape from double taxation. Since choosing a business structure may be a complicated process with long-range consequences, you should consult your Smith Schafer tax professional. Here are some of the pros and cons of S corps:
ADVANTAGES of S Corporation
Like any corporate organization, an S Corp allows you and any co-owners to restrict personal liability. If, for example, your company is unable to pay its debts, the business assets would be open to creditors, but your personal belongings would be off-limits. However, you do not have total protection from liability; if your company is in the business of offering advice, for example, you won’t be protected if the advice you offer is wrong.
Treatment of Losses
If you think you might have operating losses in the first couple of years in business, an S Corp may be a wise choice. Let us say you invest $100,000 in your venture and wind up with a loss of $25,000. The deficit is passed through to you and any other owners — on a pro-rata basis — so you can take the loss against other income on your personal tax returns. However, you cannot take current-year losses that exceed your adjusted basis in the company.
A corporation’s S status may be terminated either voluntarily or involuntarily. Voluntary termination requires a vote of shareholders owning more than 50 percent of the company’s total outstanding voting shares. Involuntary termination can result from not following the restrictions placed on S corps. Refer to other S Status Restrictions.
Pro-rata taxable income and dividend distributions are free of FICA taxes (Medicare and Social Security). Company contributions to a retirement plan on behalf of a shareholder-employee are also generally not subject to FICA taxes. In a family business, you may be able to get some tax advantages by shifting the owners’ income to other family members by making them employees or shareholders, or both.
Warning: The prospect of major employment tax savings may tempt you to cut your compensation and take large dividend distributions instead of salary. But the IRS keeps a keen eye on “reasonable compensation.” If the tax agency finds that compensation is inadequate, it can recharacterize your dividend distributions as wages, which means you become liable for unpaid employment taxes, penalties, and interest.
TAX-FAVORABLE TREATMENT OF INCOME
S Corp shareholders can be employees of the business and draw wages as employees. They can also receive distributions that are tax-free to the extent of their investment in the corporation. This reasonable treatment can help reduce self-employment tax liability.
TRANSFER OF OWNERSHIP
In an S Corporation (S Corp), the transfer of ownership involves the sale, gifting, or transfer of shares or ownership interests in the company from one shareholder to another. Unlike C Corporations, S Corps have certain restrictions and requirements regarding the transfer of ownership to maintain their tax status as a pass-through entity.
METHOD OF ACCOUNTING
S corps can choose to use the cash basis of accounting in most cases, where as a C Corp must use the accrual method of accounting in most cases.
DISADVANTAGES of S Corporations
If your company owns any assets that have been appreciated, they cannot be distributed to you and your co-owners without generating a tax bill.
Taking money or assets out of an S corporation may be an administrative headache. For example, the withdrawal must be characterized for tax purposes as compensation, a dividend, a loan, or other payment. Compensation means payroll taxes are due, and W-2 forms and payroll tax returns must be filed. A loan requires a loan document.
Single Stock Class
It can be difficult to raise cash through a stock offering because an S corporation can issue only one class of stock, which must have identical rights regarding dividends and the distribution of company assets if the business is light can be difficult to raise cash through a stock offering because an S corporation can issue only one class of stock, which must have identical rights regarding dividends and the distribution of company assets if the business is liquidated.
TAXABLE FRINGE BENEFITS
In most cases, fringe benefits provided to more than 2 percent employee-shareholders are treated as taxable compensation.
OTHER S STATUS RESTRICTIONS
- The corporation must be domestic.
- There must be no more than 100 shareholders.
- The shareholders must be U.S. citizens, resident aliens, estates, certain types of trusts, or tax-exempt entities.
Ultimately, an S Corp provides a good option for a small enterprise that would otherwise be significantly taxed under the ultimately, an S Corp provides a good option for a small enterprise that would otherwise be significantly taxed under the traditional corporate model. When selecting or considering a new legal structure, business owners should always review their options with your Smith Schafer professional. For additional details on legal entity analysis and the selection or to learn more about how we can help, please contact a Smith Schafer professional. Click here to contact us. We look forward to speaking with you soon.