What are the Benefits of Making an S-Corp Election?
As your small business grows you may want to consider a certain tax designation for your business known as an S-corp
As a small business owner, it is very important that you choose the proper, most advantageous taxation structure for your company. Many businesses start off as sole proprietorships or partnerships, but as they grow, their needs change. One tax designation to consider for your growing small business is known as an S-corporation, or S-corp. To be clear, you do not have to be a Corporation (“Inc.”) to be treated as an S-Corp–you can also elect to do so as an LLC.
What Is an “S-Corp”?
While an S-corp is often spoken of as if it is a business structure, there is some nuance to consider here. An S-corp is not a legal business structure like an LLC or a sole proprietorship. Rather, it is a specific business designation for tax purposes. Some businesses are legally structured as LLCs, but taxed as S-corporations.
In fact, the way business income is taxed is the defining characteristic of an S-corp. Once your business is designated as an S-corp, the profits and losses can be passed through to owners’ personal income taxes. They won’t first be taxed as corporate income as they would be if a business were designated as a C-corp.
S-corps are separate entities from their owners or shareholders. Shareholders can leave or sell their shares, and the S-corp can remain intact.
The IRS is responsible for designating businesses as S-corps. In order to qualify as an S-corp in Florida, a business must meet the following criteria:
- There must be 100 or fewer shareholders.
- All shareholders must be legal U.S. citizens or residents.
- The corporation may issue only one type of stock.
- The company must be a domestic business.
Certain classes of businesses are ineligible to apply for S-corp status. These include insurance companies, some financial institutions and banks, and international sales companies.
Benefits of Forming an S-Corp
Business formation is time-consuming, and registering your business as an S-corp is a big step that involves a lot of paperwork and legal guidance. So, why do business owners go through this trouble? As it turns out, forming an S-corp comes with significant tax advantages.
S-corporations do not pay federal income taxes like C-corporations. They instead pass their profits directly on to their shareholders, who pay personal income tax on those profits. This arrangement allows business owners to escape the famous double taxation experienced by owners of C-corps.
S-corp owners can also modify the ways in which they receive their income in order to minimize their tax burden. For example, a shareholder can receive income as an employee, as well as via shareholder distributions, which are oftentimes taxed at a lower rate than W-2 income. It’s up to the shareholders to designate income in a way that provides the greatest tax advantage for each individual. NOTE: The IRS does require employees of an S-Corp to still draw a “reasonable” salary. What “reasonable” means will depend on your industry, number of years in business, and skill/education. You are encouraged to seek the advice of an experienced CPA or accountant on this.
Should You Form an S-Corp?
While many businesses do benefit from being designated as an S-corp, this designation is not appropriate for every situation. There are a few small drawbacks to consider when deciding whether to form an S-corp–mainly the restrictions set forth above. For instance, the entity treated as an S-corp can no longer be owned by unrelated LLCs or corporations.
Forming an S-corp can boost your credibility with creditors and investors. So, if you are trying to grow your company, this may be a smart move. Then again, designating an S-corp too early, when you’re not able to pay yourself a reasonable salary, can raise red flags with the IRS. The IRS does pay close attention to S-corps and wants to see employees being paid a reasonable salary. For this reason, it is important to time your S-corp designation well when growing your business.
Just like seeking the advice of a business attorney for formation matters, the best way to figure out the most advantageous tax structure for your business is to talk to a seasoned CPA or accountant who can help you choose the structure that’s best suited to your needs. A qualified business attorney can also work alongside your CPA to address any necessary changes to your legal documents (such as an LLC’s Operating Agreement).