As you start down the road to forming your own business and learning how to incorporate a business, one of your first decisions is choosing the type of entity your business will take. This choice often comes down to forming a corporation or an LLC. If the corporate option is selected, many new business owners immediately turn their sights to the S corporation election to avoid double taxation.
There's a common misconception that the S Corporation election allows a business to enjoy the best of both worlds (a real corporation with the characteristics of an LLC), but this is not entirely true. Many also believe that S Corporations are identical to standard C Corporations, except for the pass-through taxation aspect. This also is not true, as a corporation must meet these requirements before electing to be an S Corp:
There's a common misconception that the S Corporation election allows a business to enjoy the best of both worlds (a real corporation with the characteristics of an LLC), but this is not entirely true. Many also believe that S Corporations are identical to standard C Corporations, except for the pass-through taxation aspect. This also is not true, as a corporation must meet these requirements before electing to be an S Corp:
- The corporation must be a US corporation,
- There cannot be more than 100 shareholders,
- There can only be one class of stock,
- All stockholders must be US citizens or resident aliens, and
- Shareholders must be individuals. This means shareholders cannot be LLCs, for example, but some trusts or estates will still qualify.
This means that automatically an S Corporation will lose some of the advantages of a true corporation. There are advantages that may make it worthwhile, however. Once a corporation qualifies for and elects S Corp status, losses will flow to individual shareholders. An S Corp also enjoys pass-through taxation, just like an LLC, and they are not subject to the 20% IRS Alternative Minimum Tax. In general, accumulated earnings taxes aren't levied on retained earnings over $250,000 as well.
Despite these benefits, there are real drawbacks. S Corp status is not a one-size-fits-all option, as it does place a great deal of shareholder restrictions on the corporation. Shareholders will also be taxed on all income, even if it isn't received, and profits are reported in a way that shareholders may be pushed into a higher tax bracket. The fringe tax benefits C Corporations enjoy will also be wiped out, and owners must take a reasonable salary. This is necessary even if the corporation isn't profitable, and this salary will be subject to employment tax. Finally, corporations that elect to be an S Corporation will face greater scrutiny by the Internal Revenue Service.
All of this isn't to say that S Corporations aren't the best choice in many cases. Still, more businesses than ever are choosing to form an LLC given its easier requirements, pass-through taxation and low costs. It's best to speak with an attorney or corporate service company prior to making this very important decision, as it will have long-lasting consequences and it may be costly and difficult to switch entities down the road.
Despite these benefits, there are real drawbacks. S Corp status is not a one-size-fits-all option, as it does place a great deal of shareholder restrictions on the corporation. Shareholders will also be taxed on all income, even if it isn't received, and profits are reported in a way that shareholders may be pushed into a higher tax bracket. The fringe tax benefits C Corporations enjoy will also be wiped out, and owners must take a reasonable salary. This is necessary even if the corporation isn't profitable, and this salary will be subject to employment tax. Finally, corporations that elect to be an S Corporation will face greater scrutiny by the Internal Revenue Service.
All of this isn't to say that S Corporations aren't the best choice in many cases. Still, more businesses than ever are choosing to form an LLC given its easier requirements, pass-through taxation and low costs. It's best to speak with an attorney or corporate service company prior to making this very important decision, as it will have long-lasting consequences and it may be costly and difficult to switch entities down the road.