Should your startup become an S-Corp?
Whether you’re just launching your startup or you’re established and expanding, you may be wondering about the benefits of becoming an S corporation.
In this blog post, we'll cover the advantages and disadvantages of S corporations, as well as how to set one up. Here's what you need to know.
What is an S corporation?
The first thing to know is that an S corporation (commonly called an “S-Corp”) is an IRS tax classification — not a type of business entity.
An S corporation is a corporation that’s treated as a 'pass-through entity' for federal tax purposes. The “S” in 'S-Corp' refers to Subchapter S in Chapter 1 of the Internal Revenue Service’s tax code.
How S-Corps are taxed.
If a business is a pass-through entity, that means its profits, losses, deductions, and credits are passed along to its owners, known as "shareholders." The owners report this information (and pay the associated taxes) on their personal income tax returns.
S corp tax status is an attractive choice because it offers liability protection and tax savings while making it easier to transfer business interests.
This federal status allows S corporation shareholders to avoid double taxation on any corporate income. Double taxation means revenue is taxed on both the corporate and individual income tax levels. This is the norm for shareholders of C corporations, the most common type of corporation.
If a C-Corp makes a profit and wants to distribute dividends to its shareholders, it first has to pay taxes at the corporate rate, and then shareholders pay taxes at their individual rate. But as an S-corp owner, you’re only taxed once, subject to your personal tax rate.
S-Corp owners also receive limited liability protection. Forming an S-Corp legally separates the business and its owners. As a result, shareholders aren’t personally responsible for business debts or liabilities.
Lenders or creditors can’t pursue your personal assets, like your house or car, unless you’ve agreed to a personal guarantee when taking on the loan or credit. This fact also distinguishes S-Corps from sole proprietorships and partnerships, which don’t shield owners from personal liability.
As we mentioned earlier, you can’t actually register your business as an S corporation. Instead, you’ll elect S corporation status for your corporation or limited liability company (LLC) after forming it. But not all startup owners are eligible to elect S-Corp status.
What businesses are eligible for S corporation status?
In order to choose S-Corp status, you have to meet certain IRS criteria. Your business must:
- Be a domestic corporation. Your business has to be based and operating in the United States.
- Have only allowable shareholders. S corp shareholders can be individuals, certain trusts, and estates. They can’t be partnerships, corporations, or non-resident alien shareholders.
- Have no more than 100 shareholders. The number of shareholders can’t exceed this limit at any point in the company's existence.
- Have only one class of stock. You can’t offer multiple types of stock, like common stock and preferred stock, to employees or investors.
- Be an eligible business type. Certain businesses, including financial institutions, insurance companies, and sales corporations, aren’t allowed to form S corporations.
These guidelines cover federal requirements, but your state or municipality may have additional rules. Check with your state filing office — usually the Secretary of State office — to see if there are other criteria.
The advantages of S-Corps.
S-Corps provide powerful tax benefits and are particularly useful if you need to sell or discontinue your business. See if any of these S-Corp advantages align with your business plan and long-term goals:
1. Pass-through taxation.
S corps don’t pay business taxes. Business profits or losses are passed through to shareholders who report it on their individual tax returns. This lets S corps avoid double taxation. That said, if your personal tax rate exceeds the corporate tax rate, this tax benefit could actually become a disadvantage.
2. Reduced self-employment tax.
With an S-Corp, taxable business income is divided into two parts: distribution and salary. S-Corp shareholders can be both owners and employees, which means you can draw a salary.
You’ll only pay self-employment tax, like Social Security taxes and Medicare taxes, on the salary portion. All together, this allows you to exercise some control over your tax liabilities. The lower the salary, the fewer taxes owed. To maintain S-Corp status, however, you have to pay yourself a “reasonable salary.” The IRS could view an unreasonable division as an attempt to avoid paying taxes and revoke your eligibility.
3. Personal liability protection.
S corporations protect the personal assets of owners. There’s no personal responsibility for the company’s debts and liabilities, which means your personal assets can’t be seized as payment. It’s important to note that many, but not all, states recognize the legal protections offered by S-Corps. Check your state laws.
4. Independent lifespan.
If you need to depart the company, having S corp status can simplify and speed up the process. S-Corps have an independent lifespan and aren’t tied to the owner’s life or involvement. That makes it easier to sell, transfer, or grow your company.
The disadvantages of S-corps.
Every business structure and tax status has inherent drawbacks. Here are the main S-Corp disadvantages you need to be aware of:
1. Strict requirements and limitations.
Your business has to abide by a number of rules to maintain its S-Corp eligibility. You’re limited to one stock class, and you can’t have more than 100 owners. Owners must be paid a reasonable salary based on market conditions, even if you’re struggling with profitability.
The IRS doesn't offer specific salary numbers, but you can find guidelines in Publication 535, under Test 1 — Reasonableness. Also, S corps must establish the calendar year as their tax year in most cases. Violate a rule, and you could quickly go from tax-exempt to double taxation.
2. Not recognized in every state.
Some states and jurisdictions, like Louisiana, don’t recognize federal S corporation elections. They may levy state taxes and fees as if you’re a traditional corporation. For instance, even though Texas recognizes S-Corp status, S-Corps are still charged the corporate franchise tax. The law is complex and varies widely by location, so review your state’s laws.
3. Corporate rules and protocol.
S corps have to log meeting minutes, hold bylaws, practice strict recordkeeping, and file certain federal and state reports — just like any other corporation. Business owners without finance management experience may need to hire an experienced accountant, bookkeeper, or tax professional to stay compliant.
How to become an S corporation.
Once you’ve determined you’re eligible, electing S corporation status isn’t as complex as it may seem. We can break down the application process into three simple steps:
- File articles of incorporation or organization with your state office, and pay any required fees.
- File Form 2553 with the IRS after it’s been signed by all shareholders. Determine your filing deadline The Tax Adviser's guide. Generally, the cutoff is March 15.
- Receive S corporation status confirmation and manage taxes at the individual level.
Both new businesses and long-lived companies can see serious tax advantages by electing S corporation status. You’ll also enjoy the risk-reducing liability protections offered by other common business structures.
That said, not all businesses are better off using this status. Your team has to be prepared to keep up with federal and state requirements around accounting, reporting, and record-keeping. If your investors are other corporations or partnerships, or you need to offer multiple stock classes, an S corp won’t work.
As long as you familiarize yourself with IRS rules and rely on an accountant when needed, you’re prepared to start and maintain your S corporation.