5 Reasons an S Corporation Might Be Right for Your Business
Anderson Business Advisors
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Most small business owners think they know the difference between C corporations and S corporations, but new tax law changes and common misunderstandings about S corporations often get business owners in trouble with the Internal Revenue Service. S corporations can–but don’t always–save you money when it comes to taxes. There are several reasons why an S corporation might be the right choice for your business entity.
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5 Reasons an S Corporation Might Be Right for Your Business
The S corporation is the appropriate choice for you if you’re a small business owner looking to pull a reasonable salary and protect your investments (house, car, properties, stocks, nest eggs). S corporations usually decrease your tax burden–and your investors’ tax liability–while loosening the eligibility requirements for your investors and providing more privacy protections than most other corporation forms. An S corporation is perfect for you if you have low-to-zero physical overhead, aim to sublimate all yearly earnings into personal income, and do not carry appreciating investments year after year.
1. Provides Personal Asset Protection
If you are currently operating your business as a sole proprietorship or general proprietorship, you could lose your personal assets if your business entity is sued. Besides forming a Limited Liability Corporation (LLC), you have two additional choices for protecting your personal assets: C corporation and S corporation.
C corporations, S corporations, and LLCs all grant the shareholders limited liability, ensuring that your personal assets aren’t exposed to your corporate actions. Both S corporations and LLCs allow pass-through taxation, meaning that S corporations and LLCs do not have to file a corporate tax return, and owners simply report the profit or loss of their share on their individual income tax return.
Filing a business under Chapter “C” in the Internal Revenue Code means that it is a “profit corporation,” and as such is taxed once at the corporate level and again when owners earn taxable income from shares. This is what is referred to as double taxation.
Filing a business under Chapter “S” in the Internal Revenue Code indicates that it will operate like a C-corporation but be taxed in the same way as a non-incorporated business. This allows protection for shareholders while passing earnings or losses directly to owners.
There are certain circumstances where?forming a C corporation ?is more advantageous for business owners than an S corporation, such as when C corporations reinvest retained earnings as a way to lower their taxes.
2. Lowers Your Tax Liability
For small businesses, such as family businesses, professionals, service, sales, or retail, you can register as an S corporation to avoid being labeled as a personal service corporation (PSC) by the IRS and having your profits taxed at a higher rate.
When comparing C corporation vs. S corporation, keep in mind that the IRS will designate any service offered to the general public as a PSC. The tax rate associated with a C corporation that’s labeled a PSC is a whopping 35%.
Forming an S corporation instead would result in tax savings, as long as you earn a reasonable compensation as salary and treat additional earnings as passive income on your tax return. S corporations pay 0% federal income tax, because all income deductions, profits, and losses pass through to individual S corporation shareholders, who then report those profits and losses as taxable income as part of their individual tax returns.
S corporations help with the tax liability of the owner-operators. Incorporating as an S corporation means that your business entity is effectively split from you, the owner. As such, you are then permitted to pay yourself both salary and benefits, but they’re subject to FICA tax. By forming an S corporation and slicing off additional income as passive income, you can avoid paying both portions of social security and Medicare on all of your income, which usually adds up to more than 15%. By dividing up your total earnings between a reasonable compensation figure for your salary and treating the rest as a distribution, your total tax liability is lower because your passive income is taxed at a lower rate.
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3. Prioritizes Your Privacy
When you form an S corporation, you’re forming a new legal entity separate and distinct from yourself. This ensures that the corporate entity, not you, is responsible for all of the actions and activities of your business. By incorporating, you are protecting yourself from being personally named in a suit by shielding yourself with the corporate entity.
If your company is threatened by a lawsuit, an S corporation can help protect information regarding your ownership and involvement with the company. Privacy can vary by state: Wyoming provides particularly strong protection, and will not post your name publicly as a member of the corporation. Nevada also affords strong protections, although they do publish the member and managers of the corporation publicly and as such you will need to hire a proxy.
4. Offers Limited Liability to Unlimited Managers
One of the main advantages of an S corporation is that it provides limited liability–not just for your shareholders, but also for management. In addition, you are allowed to appoint unlimited management and are not restricted to any particular state residency requirements as part of your S corporation requirements.
Corporate membership is dictated by the by-laws of your corporation. S corporations allow you to bestow membership upon up to 100 individuals, as long as the shareholder is not a corporation and is a U.S. citizen (or permanent resident). Shareholders in an S corporation must be individuals, estates, or other special tax-exempt trust entities. Family members are counted as one shareholder, so a child and two parents owning S-corporation stock would count as a single shareholder total.
S corporation tax advantages are revoked and penalties are retroactively applied if any share of the S corporation is found to be owned by an LLC, partnership, most types of trusts, another corporation, or non-U.S. citizen/resident. If you want to have these types of shareholders, filing an LLC may be right for you. S-corporations are the best choice for those that wish to retain unlimited flexibility with regards to scaling their management– as long as you do not mind limiting the number of investors to 100.
5. 100% of Your Business Profits Go to Earnings
If you usually pass all of your business profits through to earnings anyways, an S corporation is right for you. S corporations are not the appropriate corporate entity choice when you expect to use your yearly earnings for expansion or if you need to retain those earnings for capital reinvestment. If you aim to reinvest your earnings or aim to earn a significant portion of your income passively, you might not want to file as an S corporation and a C corporation may be more appropriate for you.
As the top?personal income tax rate is now higher ?than the top corporate tax rate, you may wish to file as a C-corporation to retain some or all of your business’ earnings rather than passing the entire amount through (as with S corporation and LLCs) in order to create the lowest possible tax liability for you and your business.
S corporations are particularly vulnerable to large tax bills on large appreciating investments. If you plan on selling assets and experience capital gains on those assets, you may be better off with an LLC or a sole proprietorship.
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