Determining which type of corporation is suitable for your business can be a tedious and confusing task. Two types of corporations are acknowledged by the Internal Revenue Service (IRS) to decide the federal income tax impositions are C corporations and S corporations. Earlier we discussed C Corporations, now let’s see what an S corporation is and how it can benefit your business.
What is an S Corporation?
The S corporation blends the best characteristics of being a sole proprietor and a C corporation. An S corporation is a special business structure of ownership, protecting against personal liability while enabling you to pay income taxes on your personal tax returns, which results in avoiding the double-taxation experienced by C corporations. Since the pass-through taxation and the liability protection are the biggest perks of S corporations, S corporation also has four major regulations that need to be maintained:
- It must be a domestic corporation
- It must involve only eligible shareholders
- It cannot include more than 100 shareholders
- It must have only one class of stock
General Characteristics of S Corporation
S corporations are not allowed to have more than 100 stockholders. Also, they cannot have partnerships, C corporations, and non-residents as their stockholders. When a corporation chooses to function as an S corporation, each shareholder must admit to participate in the elections, sign the application to the IRS, and agree to a financial year for the corporation.
The S corporations do not pay corporate taxes instead they shift their losses, income, credits, and deductions to their shareholders in the transaction called distributions. The distributions are mentioned by the corporation on K-1 forms and are published on the stockholders’ personal income tax returns. S corporations are required to file annual federation tax returns indicating the income and distributions. They also need to file annual reports and tax returns as required in the states where they operate or are chartered.
Although pass-through features and tax benefits can make S Corporations attractive, some states do not fully identify them, so they may tax as they do for C Corporations. Also, many states impose annual report filing fees or franchise fees for a small business; it might lessen the visible benefits of an S Corp. To know whether an S Corp is right for your business or not, consult a professional CPA who can explain you the state’s corporate regulations.
S Corporations work in the same way as any other corporations, they need to pay salaries, social security insurance taxes for employees and individual income. In an S Corporation, wages are subject to withholding, but distributions to shareholders are not. Employee benefits, ordinary business expenses, owner’s retirement funds count the same as any other corporation, but the dividends earned from the stock are not deducted by the corporation — it is passed along to shareholders. Also, charitable deductions are not limited to S Corps. Any losses can be carried forward and applied gradually over a 20-year period.
Advantages of S Corporation
An S corporation shields the personal assets of its shareholders. Creditors cannot reach the personal assets such as personal bank accounts, house, etc. of the shareholders to pay the business debts.
Easy transfer of ownership
The S corporation does not require making any adjustments to the property basis or adhering to complicated accounting rules when an ownership interest is transferred, it can be freely transferred without any adverse tax consequences.
The most prominent advantage of an S Corp is that it does not pay federal taxes at the corporate level. The profits and losses earned are “passed through” to shareholders who then report it on their personal income tax returns. This can be remarkably helpful in the start-up phase of new businesses because a business that does not choose an S corporation status and collects passive income is in danger of being classified as a personal holding company.
Double Taxation Eliminated
In an S Corp, the income is not taxed twice, i.e., once as a corporate income and again as a dividend income.
Yearly Tax Filing Requirement
The S Corporations have once in a year tax filing requirement, whereas in a C Corp it is required to be filed quarterly.
Disadvantages of S Corporation
Formation and ongoing expenses
To form an S Corporation, it is essential to incorporate the business by filing the Articles of Incorporation with your state, hire a registered agent and pay the required fees. Many states may also impose the ongoing fees such as franchise tax fees or annual report fees.
Stock ownership restrictions
The S corporation is allowed to have only one class of stock, even though it can have both voting and non-voting shares. Hence, there can’t be different classes of investors who are designated to different dividends or distribution rights. Also, one more drawback of forming an S Corporation is that there cannot be more than 100 shareholders and foreign ownership is prohibited.
Tax qualification obligations
If there are any mistakes or confusions regarding the stock ownership, election, consent, notification, and filing requirements, it may accidentally result in the termination of an S corporation status.
Closer IRS scrutiny
Since the amounts shared with the shareholders can be dividends or salary; the IRS examines the payment closely to ensure that the characterization agrees with the reality. This, in result causes the wages to be re-characterized as dividends and costing the corporation a deduction for the compensation paid. Vice Versa, the dividends can also be re-characterized as wages, which governs the corporation to employment tax liability.
Less flexibility in allotting income and loss
The S Corporation cannot efficiently allocate income or losses to particular shareholders. Stock ownership governs the allocation of income and loss. Also, the accumulated adjustment account can be inconvenient to maintain, requiring input from an accounting professional.
Deciding a business type for your business is never easy. It is always advisable to familiarize yourself with the procedure of company formation. However, in the end, an informed decision should be made in consultation with the legal counsel or attorneys who are specialized in corporate law.