An S corporation (S corp), is a business entity classification under IRS rules. There are tax and other legal advantages and disadvantages to creating an S corp. Before you decide, look at the facts and benefits of selecting an S corp.
Basic Business Entities:
As soon as your business earns that first dollar, you are either a sole proprietor or a general partnership. These are the default business entities. However, depending on the size and type of business you have, you may decide to form a Corporation or Limited Liability Company (LLC.) The primary advantage of incorporation is that you and your partners can shield your personal assets if the business is sued. For example, if you run a bakery that delivers cakes and your driver causes an accident, you are unlikely to risk losing your house in a lawsuit.
Incorporation and LLC creation rules vary by state. Once you decide, contact your Secretary of State to get the rules, forms, and costs of creating your business entity.
S Corp Election
You have your certificate of incorporation. Now what? To claim the benefits of an S corp, you must file IRS Form 2553 within the first 2 months and 15 days of the tax year to claim S corp status for the tax year.
Pros and Cons of an S Corp
The S corp laws allow small businesses to enjoy some of the legal and tax benefits of larger businesses. But with those benefits comes additional responsibilities.
- S corps have tighter operating and documentation requirements. Your business must hold director and shareholder meetings, maintain by-laws, and keep more detailed records.
- S corps have additional tax filing requirements and earlier tax deadlines. Failure to meet these requirements can result in significant financial penalties.
- There are tighter compensation requirements for shareholders. Salaries must be reasonable or you could be inviting an audit. All of the tax benefits can be lost if distributions are reclassified as wages and subject to employment taxes.
But for some businesses, the benefits far outweigh the additional burdens.
- S corps can see substantial savings on taxes. A properly set up program of earnings dispersal can result in lower employment taxes and a lower tax rate for income distributions.
- Shareholder benefits can often be written off as business expenses.
- The business may see advantages in negotiating for group health insurance plans.
- You can separate the business from your personal financial life. Once a corporation is created, it is a separate legal entity from you and your partners. The business itself has a seat at the table. This can make it easy for a shareholder to retire, transfer shares to another person, or buy out a partner.
- Real estate transfers can be streamlined. The corporation holds the deeds to all business-related real estate. If a new partner is brought on board or one departs, there is no need to execute deeds to transfer ownership of the property.
- Estate planning is simplified. Business shares are bequeathed to heirs without having to worry about listing individual assets and accounts.Instead of this heir getting a bank account, and this heir getting real estate, each is given shares of the business. This can also prevent disagreements that might damage the continued operations.
S corps aren’t for every business. To determine if it is right for you and to set up the programs and safeguards you need to receive the maximum legal benefits, contact us for a consultation.