An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.
To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which you (the owner, or “shareholder”) are responsible.
Is this the right structure for your business? To help you decide, these are the main pros and cons of doing business as an S Corporation:
Advantages of an S Corporation
- Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
- Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. (However, if an employee owns 2% or more of the S Corp, benefits like health and life insurance are deemed taxable income.)
- Independent Life. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed.
Disadvantages of an S Corporation
- Stricter Operational Processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.
- Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages.
**This article is designed to provide helpful information that can be read within 2 minutes. It is neither a full explanation of this subject nor legal advice. To learn more, and to get legal advice on which you can rely, contact me or another lawyer.
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