S Corporation Overview
Choosing to classify your limited liability company (LLC) as an S corporation (S corp) with the Internal Revenue Service (IRS) can have tax advantages. S corp owners are taxed as employees of the company and don’t have to pay self-employment tax on dividends and distributions.
In the United States, an S corporation is a corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code. By contrast, a C corporation is a corporation that has not elected to be taxed under Subchapter S and is therefore subject to corporate income tax.
An S corporation and an LLC both offer liability protection to the business owners and shareholders. Both business entities are legally separate from the owner or shareholders. In the event of a lawsuit or a creditor collection, the owner’s personal assets are protected from business risks and debts.
Tax Implications of S Corporations
C corporations pay tax on their income at the corporate level, and shareholders pay taxes on the profits distributed as dividends. On the other hand, S corporations don’t pay income taxes directly. Instead, they file an informational return that reports income and expenses to the IRS, with profits or losses then reported on the owners’ personal tax returns.
Some states, like California, levy a franchise tax on the S corporation’s profit, while others, such as Tennessee, do not allow the use of S corporation accounting for state tax purposes. For state taxes, every state has its own laws and regulations regarding S Corp taxation.
Pros and Cons of S Corporation Status
There is no limit to the number of managers in an S corporation, and there is no state residency requirement. However, passing income through to shareholders can be a disadvantage in profitable times, as shareholders are required to pay income tax on their share of the profits, even if that money is not distributed to them.
Electing S-Corporation status means that income or losses are passed to the shareholders, who recognize them on their personal tax returns.
Advantages:
- Tax advantage: Avoid double taxation.
- Save payroll taxes: Dividends and other distributions are tax-free.
- Transfer of ownership: Interests can be transferred without adverse tax consequences.
Disadvantages:
- Passing income to shareholders may increase personal taxes for some.
- Shareholder constraints could potentially affect business expansion options.
Electing for S Corporation Status
The S election is a tax election for corporations to be taxed as a Small Business Corporation (SBC). To make an S election, a corporation must be in good standing with the IRS, have fewer than 100 shareholders, and all shareholders must be U.S. citizens or residents. Additionally, an LLC can elect to be taxed as a corporation and then make the S corporation election under section 1362(a).
An S Corporation is a specific type of corporation created by filing an IRS tax election. This allows the company to avoid double taxation while protecting the owner from liability. About 70 percent of all corporations choose to be an S Corp.
Final Considerations
When establishing your business entity, consider the pros and cons of each structure. An S corp can provide tax advantages and ownership flexibility over a C corporation. If considering S-Corp status, consulting with a tax professional is advisable.
Remember, this post is for informational purposes only and does not constitute legal, business, or tax advice. Always consult with professional advisors regarding your specific situation.