When you work for yourself, you can structure your business in multiple ways. Many entrepreneurs choose to establish S Corps for tax advantages and perceived legitimacy. However, the setup doesn’t make sense for every organization.
Should your business become an S Corp? Keep reading to learn the facts.
What is an S Corp?
An S corporation, or S Corp, is a special type taxed differently from regular C corporations. S Corps are pass-through entities, which means that they don’t pay corporate income taxes. Business profits “pass” to the owners and are declared on their personal tax returns.
Why does this matter? If your business is a C corporation, the business pays taxes on its profits, and you pay taxes on any income you take home, leading to double taxation.
If you operate as a sole proprietor, partnership, or LLC, you pay self-employment taxes for the business’s entire income.
S Corps avoid these issues. In an S corporation, you can become an employee of the business and pay yourself a reasonable salary, taking the rest of your profits as distributions or dividends. Your wages are subject to Social Security and Medicare taxes, which are about the equivalent of self-employment taxes, but the distributions aren’t.
Is Your Business Eligible?
S Corp status is only attainable by certain businesses. To be eligible, your business must:
- Be based in the USA
- Have 100 or less shareholders
- Have no corporate partners or foreign investors.
Additional rules include that you can only offer a single class of stock and can’t be a prohibited business such as a financial institution or insurance company.
S Corp Benefits
Forming an S Corp has these benefits:
Tax Savings
As mentioned, establishing an S corporation can prevent double taxation. You’ll pay Social Security and Medicare taxes only on your salary and not on profit distributions, often lowering your overall tax liability.
Limited Liability Protection
Like C corporations, S Corps offer owners limited liability protection, protecting personal assets like your car or house from business debts.
Perceived Legitimacy
Clients and investors may view your organization as more legitimate if it has “Inc.” attached to its name.
Perpetual Existence
S Corps have perpetual existence, meaning the business continues to operate regardless of changes in ownership. This could be helpful if you plan to pass the business down to your children.
S Corp Drawbacks
Of course, S Corps have drawbacks, too. Here’s what they are:
Additional Costs
As an S Corp, you’ll need to pay your salary and payroll taxes every month. Many S Corps use payroll software to handle the payments and are responsible for payroll processing fees as well.
Extra Formalities
S Corps require specific paperwork and formalities. You’ll need to file articles of incorporation, hold shareholder meetings, and keep detailed financial records.
It may be difficult to remain compliant without expert help.
Increased Scrutiny from the IRS
S Corps can attract increased scrutiny from the IRS. The agency may be more likely to audit your returns, especially if you have a low salary and take most of your income as distributions.
Varies By State
Some states don’t recognize S Corps and tax them the same as traditional corporations.
Is an S Corp Right for You?
Deciding whether to form an S Corp depends on your specific circumstances and long-term business goals. Here are some questions to consider:
- Does your business make enough money? Setting up an S Corp may not be in your financial interests if your business would have trouble absorbing the extra costs.
- Are you primarily concerned with minimizing taxes? If tax savings are a primary concern and your profits are large enough, an S Corp might be a good fit.
- Can you comply with the formalities required by an S Corp? If you’re willing to adhere to the regulations, the benefits might outweigh the administrative burden.
Take the Next Step
At Kondler & Associates, CPAs, we understand how to help business owners choose the formation that works best for the situation. Contact us today to schedule a consultation and take the next step toward maximizing your profits and protecting your assets.
