What is an S Corporation?

What is an S Corporation?

Selecting the structure of your small business is an important decision that you'll need to make early on when you launch your business. The initial structure that you choose for your business affects your business later on. It can affect how your business handles taxes, legalities, as well as general operations.

Take your time and conduct the proper research on the various types of business structures to determine which one will be best for you. The main types of business structures to choose from are: limited liability company (LLC), sole proprietorship, S corporation, and a C corporation.

With an S corporation (S Corp), the income generated by the company is passed on to shareholders. Also, passed on to shareholders are deductions, losses, and credits. An S Corp alleviates the issue of double taxation, allowing business owners to pass-through the business profits onto their personal income tax. To establish your S Corp, you need to be established as a corporation first.

To get started with an S corporation simply submit necessary documents, such as your Certificate of Incorporation or Articles of Incorporation, to the proper government office. Oftentimes, the government website will display the fee that corresponds with the documents you wish to submit.

When your business has completed Incorporation, Form 2553 needs to be signed by all of the shareholders to receive S corporation status. Taxes are dealt with on an individual level on individual tax returns rather than on the corporate level.

In order to receive S Corporation designation from the IRS, the corporation must:

- Be located within the US

- Have shareholders that qualify, including estates, trust, and individuals, excluding non-resident aliens, partnerships, and corporations

- Include less than 100 shareholders

- Include only one class of stock

- Not be an ineligible corporation (i.e., insurance business, financial institutions)

Self-Employment taxation

Business income can be divided into two parts; distribution and salary. Self-employment tax is only applicable to the salary portion rather than distribution and salary. LLCs, sole proprietorships, and partnerships are taxed on the net income of the entire business.

The distributed portion of income is not taxed, allowing for a great deal of tax savings. It is acceptable to attribute 60% of your business’ income as salary. If you take too high an income, it will make it seem like you are trying to avoid taxes.

Double taxation

S corporations are taxed on passive income and specific capital gains while being exempt from income tax on a federal level. S corporations are treated much like partnerships because they do not pay corporate taxes. This is one of the main attractions of this type of business structure.

Regular corporations are subjected to being taxed twice also know as double taxation. This means that with a regular corporation, the corporation is first taxed on business income, and then the individual is also taxed on their personal salary.

Here's an example of double taxation. Let’s say your corporation generates $500,000 of income within a year. If the income is taxed at 34%, that means $170,000 is the tax paid on the corporate level. The remaining funds ($330,000) are then issued to shareholders where the income is taxed again on the individual level. If there are four shareholders they each get $82,500 which is subject to the second tax.

The advantage of an S corporation is that it will only be taxed once rather than twice, leaving more funds for salaries and business development. Shareholders report their income on form 1040 in their income tax each year. They report corporate deductions, credits, loss, and income on their personal income tax return. It's important to keep in mind that not all S corporations have the same advantages.

How your S corporation is taxed will be specific to the municipality and state of where business operations are headquartered. For example, California has a franchise tax that is a minimum of $800 or 1.5% of net business income. In New York, there is a corporate income tax at a rate of 8.85%.

However, if a New York business can prove that it has a business outside of the city, the income generated there is exempt from taxes. To file an income tax return for an S corporation, form 1120S is used. Schedule K-1 is used to report the losses, profits, and deductions of shareholders.

The life of a business

A sole proprietorship is not an independent entity, and is directly linked to the individual business owner. The proprietorship business structure cannot exist without a sole proprietor as part of the business. An S corporation has longevity, it's not contingent upon whether the shareholders leave or stay with the business. Therefore, it's easier to build towards long-term growth and goals with an S corporation.

Protecting yourself and your assets

Having an S corporation affords the business owner a certain type of protection. For example, your personal assets as a business owner and shareholder assets are under protection. This means that the debts and liabilities of the company are completely separated from shareholder responsibility.

Creditors, or anyone who sues the corporation, do not affect personal shareholder assets. Business debt is completely separate from shareholders under an S corporation but not with a partnership or sole proprietorship.

Transferring ownership

An S corporation makes it easier to transfer ownership of a corporation from one person to the other. Ownership can be transferred via a sale of the entire company, immediately changing ownership. An S corporation can also be sold gradually over time. An agreement of the sale makes the process formal and final. It's much more difficult to sell a sole proprietorship which is directly tied to the individual person.

Having an S Corporation lends your company a degree of credibility to vendors as it is a recognized and respected business structure. An S corporation requires you to follow several protocols such as scheduling meetings between shareholders and directors, proper record maintenance, formal bylaws, and further specific record-keeping necessities.

The IRS pays attention to the combination of high distributions and low salary. If this combination is discovered by the IRS they will automatically move a larger portion of your income to the salary category. When the IRS makes these changes on your behalf, it inevitably means higher taxes for your corporation. Speaking of higher taxes, the federal income tax rate increased from 35% to 39.6% in 2013 or individual earning $400,000 or more ($450,000 jointly).

 

If you want to establish an S corporation, you will need to be detailed and possibly hire a professional to keep up with your bookkeeping, accounting, banking, and legal issues and requirements. If your company is large and growing quickly, it may be best for you to remain as a C corporation. The aforementioned business structure allows you to have no limits on the number of shareholders and the ability to offer multiple classes of stocks.

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