Moving away from your typical 9-to-5 job to initiate your own business marks a significant decision, but it’s just the start of your journey. As you step into entrepreneurship, you’ll be confronted with numerous choices. Among these, you’ll need to pick a location, establish a hiring procedure, and decide on both traditional and digital marketing approaches.
Another critical early decision is whether to establish an S corporation or not. This article aims to elucidate what an S corporation entails, the pros and cons of setting one up, and some alternative routes to ponder.
What is an S corporation?
The notion of forming a corporation might seem daunting to many entrepreneurs. However, it’s a crucial move for your business’s well-being.
Incorporating shields your personal assets, provides tax advantages, and lends your business the credibility it needs. While you have several incorporation options, many entrepreneurs opt for the setup of an S corporation, or S-corp.
An S-corp stands as a distinctive type of corporation categorized under subsection S of the tax code. To establish an S-corp, a small business owner initiates a C corporation (C-corp) in the state of its headquarters, subsequently applying for S corporation status with the IRS.
Although an S-corp shares similarities with a C corporation, differences in income and self-employment tax regulations set them apart.
Advantages of forming an S-corp
Forming an S-corp brings about notable benefits for a business owner.
1. Pass-through taxation: Similar to an LLC, an S-corp does not undergo taxation at the corporate level. Income or losses are solely reported on the business owner’s personal income taxes. This structure circumvents the issue of double taxation faced by C corporations. Additionally, net losses are “passed through,” allowing individual shareholders to potentially reduce their tax liability by offsetting other income with S-corp losses. However, it’s vital for any shareholder working for the company to receive reasonable compensation to avoid IRS reclassification of additional corporate earnings as “wages.”
2. Liability protection: According to the IRS, S-corps are legally recognized as unique entities distinct from their owners. Owners enjoy limited liability for the company’s actions, shielding them from responsibility for the company’s debts or actions unless they’ve signed a personal guarantee.
3. Exemption from self-employment taxes: Owners of an S-corp are deemed employees rather than owners. Consequently, as an employee, you’re not subject to the self-employment taxes applicable to LLC members.
4. Reduced taxable gains: Opting for an S-corp becomes even more appealing if you intend to sell your business in the future. Upon selling the company, taxable gains may be lower compared to selling a C corporation.
5. Lifespan: An S-corp presents an excellent choice for those aiming to establish a long-lasting business rather than a short-term endeavor. Unlike an LLC, an S-corp enjoys an indefinite lifespan. Even if you depart from the company, it can continue operating without significant disruption.
6. Ease of ownership change: In the event of needing to transfer ownership due to unforeseen circumstances, an S-corp allows for seamless ownership transfer through the sale of company stock. Additionally, if you find that running an S-corp isn’t suitable, you can easily revert to a different status with the IRS.
Disadvantages of an S-corp
Despite the numerous benefits, there are several drawbacks to consider:
1. Potential fees: Depending on your state, ongoing fees and expenses may be incurred. While not usually exorbitant, these fees represent costs absent in sole proprietorships.
2. Risk of costly mistakes: Errors regarding stock ownership, consent, or IRS notifications could jeopardize your S-corp status.
3. Stringent requirements: Compared to other incorporation types, an S-corp entails a rigorous management structure, necessitating the appointment of a board of directors and officers, along with annual shareholder meetings.
Other business structures to contemplate
If you’re undecided about opting for an S-corp, here are four alternatives to consider:
1. C corporation: Similar to an S-corp, a C-corp offers certain tax benefits. However, unlike an S-corp, it can have an unlimited number of shareholders, who may also be company employees. Yet, C-corporations face the risk of double taxation.
2. LLC: A limited liability company provides a separation between business and owner assets. Setting up an LLC is less costly and cumbersome compared to an S-corp.
3. Partnership: Partnerships allow members to structure the business according to their preferences, with equal profit and loss sharing among partners. However, it’s crucial to form partnerships only with trusted individuals.
4. Sole proprietorship: This structure merges the business and individual, lacking a legal separation. While simple to establish, sole proprietors face personal liability for any business-related debts or lawsuits.
