When you start a business, there are several ways to form your company. For instance, you could create a C-Corporation, a Limited Liability Company (LLC), or a Partnership, among other types of business structures. Contrary to popular belief, however, you cannot form an S-Corporation (S-Corp(s)) from the beginning, but you must go through electing the S-Corp status later on, which comes with both taxes advantages and disadvantages. Understanding these tax implications will help you determine whether this is the best business structure for your business or not. The business formation lawyers at Evolution Tax and Legal break down these advantages and disadvantages and how our team of seasoned professionals can help you form your business entity.
What Is an S-Corporation
First, it is essential to know that an S-Corp is not a type of entity. At the time you start a business, you cannot choose to form an S-Corp. In fact, an S-Corp is a type of tax classification of a corporation or an LLC that should be requested by the Internal Revenue Service (IRS). It is also called a “Subchapter S election” after the section of the IRS Code that talks about the tax treatment of S-Corps.
To qualify for S-Corp status, the corporation must submit a Form 2553, Election by a Small Business Corporation to the IRS, signed by all the shareholders, and meet the following requirements:
- Be a domestic corporation;
- Have only allowable shareholders. Shareholders may be individuals, certain trusts, and estates but may not be partnerships, corporations, or non-resident alien shareholders;
- Have no more than 100 shareholders;
- Have only one class of stock;
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic, international sales corporations).
How Are S-Corps Taxed?
An S-Corp is a regular corporation whose owners elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax (and sometimes state) purposes. In other words, an S-Corp is a pass-through entity like a partnership. Thereby, S-Corp shareholders report flow-through of income and losses on their tax returns and are assessed tax at their individual income tax rates, avoiding double-taxation. S-Corps are, however, responsible for tax on certain built-in gains and passive income at the entity level.
S-Corps also report their income and deductions, much like partnerships. An S-Corp files an information return (Form the 1120S) reporting the corporation’s income, deductions, profits, losses, and tax credits for the year. Shareholders must be provided a Schedule K-1 listing their shares of the items on the corporation’s Form 1120S. The shareholders file Schedule E with their personal tax returns (Form 1040) showing their corporation income or losses share.
What sets S-Corps apart is the employment status of the owners who work in the business. An owner that performs more than minor services for the corporation will also be its employee for tax purposes. In this case, an owner/employee must be compensated for their services with a reasonable salary and any other employee compensation the corporation wants to provide.
Employment Tax Savings
Moreover, one of the main reasons businesses elect S-Corp treatment is because it provides a way for owners to save on Social Security and Medicare taxes. Owners do not have to pay employment tax on dividends from S-Corps. Earnings and profits other than the owner’s salary will pass through the corporation to them. Thus, the larger the distribution, the less employment tax is paid. The IRS requires S-Corp shareholder-employees to pay themselves a reasonable salary. Besides, it can be advantageous for an S-Corp to pay substantial employee salaries due to the pass-through tax deduction.
Pass-Through Tax Deduction
Like other pass-through entities, S-Corps were given a new tax deduction by the Tax Cuts and Jobs Act starting in 2018. In addition to that, S-Corp shareholders may deduct up to 20% of their net business income from their income taxes whether or not they itemize.
If the business owner’s total taxable income for the year is less than $157,500 (single) or $315,000 (married, filing jointly), a shareholder of any pass-through entity qualifies for the 20% deduction. However, if the taxable income is more significant than $207,500 (single) or $415,000 (married), the owner does not qualify for the pass-through deduction unless his or her business pays employee wages or has business property. Therefore, if the business elects S-Corp status, the owner will also be an employee, paving a way to qualify him or her for the pass-through deduction. Unfortunately, for personal service businesses, such as accounting, law, health, consulting, athletics, financial services, and brokerage services, the pass-through deduction is not available if the owner’s taxable income is over $415,000 for marrieds or $207,500 for singles. This is about to change as we are awaiting the administration’s new tax reform.
Tax Advantages of an S-Corp
So far, a few advantages of an S-Corp have already been discussed. However, there are still more tax advantages for a business that elects an S-Corp status.
- The income and loss of the S-Corp are allocated pro-rata on a daily basis to each shareholder based on their ownership of all the shares of an S corp.
- Capital losses are also allocated to the shareholders based on their daily pro-rata share of total shares in the S-Corp.
- The corporation can have an unlimited life, and shares can be transferred easily to other people or entities.
- Shareholders get the maximum protection for their assets if they keep their business affairs separate from their personal affairs.
- S-Corps are not subject to the Net Investment Income tax.
- Fringe benefits for employees and owners of 2% or less of the S-Corp are not considered shareholders’ or employees’ income. They are also deductible by the S-Corp.
- A greater than 2% owner of an S-Corp can deduct 100% of health care premiums paid by the corporation under a plan established by the corporation.
Tax Disadvantages of an S-Corp
Along with the advantages of an S-Corp status, it is beneficial to look at some of the disadvantages S-Corp shareholders may face.
- An S-Corp has less flexibility in choosing a tax year.
- It has unreasonably low compensation audit exposure.
- Limited flexibility concerning the allocation of losses and profits to individual shareholders.
- Potential for involuntary termination of S-Corp status
- State tax law may not recognize an S-Corp.
- An S-Corp with more than 100 employees earning at least $5,000 in the prior year cannot claim the pension plan startup costs credit.
- Shareholders in an S-Corp may be subject to the tax on income items related to their investments in the corporation.
- There are restrictions on the ordinary income treatment on Internal Revenue Code Sec. 1244 qualified small business stock.
- Owner-employees who own more than 2% of the S-Corp stock may include fringe benefits in their gross income.
- There are limitations on some deductions that are generally itemized deductions of shareholders and certain other expenses such as alimony.
- Distributions to shareholders may be taxable if they exceed the AAA account first, earnings and profits second, and then the remaining basis in the stock.
- A deduction for health insurance benefits is not allowed in excess of the earned income of the owner-employee from that business.
- An S-Corp can have “built-in gains” if it does not become an S-Corp in its first year.
- An S-Corp can only claim a deduction for the stock given to an employee for services in the amount and the year in which the employee includes the stock in its income.
How the Business Entity Formation Lawyers at Evolution Tax and Legal Can Help
Deciding how to register your business entity is an intricate decision. It is imperative to understand the different types of entities and the benefits and disadvantages they may offer before making your final decision. It is beneficial to discuss your decision with a tax professional, to have a seasoned expert work with you and your unique business situation to decide what is best. The business entity formation attorneys at Evolution Tax and Legal have worked with countless business owners to register as a business entity and ensure they receive the benefits that will work for their business. To start your journey to becoming a business entity today, contact Evolution Tax and Legal.