S-Corporation: Is It Right for Your Business?

If you’re launching a new company, you may be so excited about your start-up idea that you may not have given much if any thought to what type of entity you will choose for your business. Without choosing an entity, you’ll end up defaulting to a sole proprietorship.  One key benefit of being a sole proprietor is that you’ll have full control over the business.   However, unlike corporations or LLCs (Limited Liability Company), with a sole proprietorship, there is no legal distinction between you and the business. As a result, there is no shield or limitation from liability. By contrast, shareholders in corporations, both S-Corporations and C-Corporations, as well as LLCs are not personally responsible for the debts and liabilities of the company.

Beyond that, you need to be forward-thinking and establish a vision for your company. As a sole proprietor, you may be hamstrung for future business growth.  For example, you may need to hire employees or seek investors and funding; those activities are easier to undertake if you have a corporate structure or an LLC.

Among the choices for how you structure or classify your business tax-wise, the S-Corporation stands out. Defined in Subchapter S, Chapter 1, of the Internal Revenue Code, the S-Corporation is an elected tax status. In addition to its positioning as a corporation—which gives it enhanced credibility with potential customers, employees, vendors, partners and investors—it is not actually a separate business entity type.

In fact, it is its tax status that is one of its greatest attractions for small businesses and the primary reason many companies choose to organize as an S-Corporation. Any income or loss is passed through to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns to reduce income tax paid. This is a benefit to small businesses, especially in their start-up phase.

More importantly,  the S-Corporation avoids the double taxation required of C-Corporations. This is actually the main reason many companies choose to organize as an S-Corporation. A regular C-Corporation is taxed at the corporate entity level and then its shareholders are taxed again at the individual income tax level. In a C-Corporation, shareholders are subject to their individual tax rate on the profits and losses passed through to them and recorded as net income on their tax returns.

For example, assume Company A has three shareholders with equal shares and reports taxable income of $1,500,000 in a year on which the company owes 21% ($315,000). The company then distributes the remaining amount ($1,185,000) among the three shareholders who each get $395,000.  The individual shareholders then must again pay tax on their $395,000.

In contrast, S-Corporations are only taxed once, because they are exempt from paying taxes at the corporate level.  The corporate income, loss, credits and deductions are passed through to shareholders for tax purposes. The shareholders then report their share of these items on their personal income tax returns.  An S-Corp is required to file Form 1120S for its corporate income tax return and the shareholders report their profits, losses, and deductions in their Schedule K-1.

Further, an S-Corporation allows a tax-favorable characterization of income. The structure offers great income-splitting potential for owners/employees who can take and pay income taxes on a smaller salary and payroll deductions (for example, Medicare and Social Security) half paid by the employee and half by the corporation. They can then take the remainder of profit as a distribution subject to income tax only.  

That being said, shareholders must establish salaries that are deemed reasonable by the IRS or risk penalty. The IRS watches closely and takes notice of unbalanced combinations such as low salary compared to high distribution and may require the company to move a larger sum to the salary component. This can lead to an unexpected income tax increase.

Still, as a business owner, you can structure your business as an LLC and enjoy the income tax benefits of an S-Corp by electing to have your business treated as an S-Corporation by the IRS for tax purposes. This dual combination allows you to benefit tax-wise while taking advantage of the flexible structure afforded by the LLC which does not require the copious registration and operational requirements of the S-Corporation.

To form an S-Corporation you must file the appropriate documents and applicable fees with the appropriate government authority. These documents are typically known as the Articles of Incorporation or Certificate of Incorporation.  Upon complete incorporation, shareholders must submit the appropriate form to the IRS to be granted S-Corporation status. 

The IRS has promulgated many requirements specific to S-Corporations which restrict the number and type of shareholders. To qualify for S-Corporation status, the IRS requires a company to have 100 or fewer shareholders. All must be U.S. citizens or permanent residents; foreigners are not allowed to be shareholders. An S-Corporation also cannot have separate classes of stock. This can limit the company’s options when seeking equity funding, as outside financiers typically require preferred shares. For this reason, if the company is a faster-growing and larger company, organizing as a C-Corporation may be a better option because of the flexibility with stock classes and no limitation on shareholders. 

In addition, some corporations are blocked from S-Corporation status. These include certain financial institutions, insurance companies, and domestic international sales corporations.  An additional requirement: the corporation is restricted to only certain types of shareholders including individuals, certain trusts, and estates. The corporation is prohibited from shareholders that are partnerships, corporations or non-resident alien shareholders.

For sole proprietorships and certain LLCs without specific duration language in their operating agreements, the life of the business is linked to the owner’s life or exit from the business.  An S-Corporation does not have this limitation as it has a life independent from the owner or owners. This duration component makes an S-Corp attractive for businesses with a long-term growth outlook, long-term goals and a desire to transfer the control of the business to family or heirs.

S-Corporations, like C-Corporations, require many corporate formalities which require meetings, recordkeeping, external professional guidance—and resultantly more costs. These include meetings of directors and shareholders, meeting minutes, by-laws, recordkeeping and the maintenance of proper corporate records.  As compared to sole proprietorships and other non-corporation entity types, S-Corporations generally need more accounting, bookkeeping, legal, and banking guidance, all areas that likely require the hiring of experienced advisors to ensure compliance.

At GARZA, we understand the many considerations that inform a decision to form as an S-Corporation. We are here to help you evaluate the various pros and cons and work with your tax and financial advisors to help you make a choice most appropriate for your business.

Call us at 208 557-8705 as you set out on your new venture. Let us help you unravel the complexity of corporate structure and tax election status and get you on track to ensure compliance.