As a Business Law Attorney my business clients often ask me if their corporation should be an S Corporation or a C Corporation. When a corporation is formed it is generally referred to as a “C Corporation” because the tax rules affecting corporations and shareholders are found within Subchapter C of Chapter 1 of the Internal Revenue Code. Becoming an “S Corporation” is actually an election that is made by filing the proper form with the Internal Revenue Service (Form 2553 Election by a Small Business Corporation). The corporation’s attorney and accountant should first be consulted before making an S Corp election. In a previous post I addressed the various types of entities to consider when starting a business. If you have already chosen a corporation as your type of business entity, or if you are considering forming a corporation, consider the following advantages and disadvantages of making an election to be treated as an S Corporation.

S Corporation Advantages

Pass-through Tax Entity Avoids Double-Taxation:

An S Corp is a pass-through entity for federal income tax purposes. Business income, credits, losses and many deductions are passed through to the owners rather than being taxed at the corporate level. This is different than a C Corp, which is a separate tax entity and must report profits and losses on a corporate tax return. It pays taxes on its profits while the shareholders are not taxed on these profits. However, when the corporation passes along any after-tax profits to shareholders in the form of dividends, the shareholders must report this as income on their personal tax returns even though the corporation has already paid the corporate taxes. This is known as “double taxation”. (Note: while double taxation is a drawback, a C Corporation has the ability to pass profits back to the company at a lower corporate tax rate).

Ability to Offset Other Income with Corporate Losses:

Unlike C Corporation Shareholders, S Corp shareholders are allowed to offset other income by including their share of the corporation’s losses on their personal tax returns provided, however, they cannot deduct corporate losses in excess of their basis in their stock – that being the amount of their investment in the company, with a few adjustments.

Salary and Dividend Payments:

An S Corp owner can opt to receive both salary and dividend payments from a corporation. This can result in an overall lower tax bill, because dividends are not subject to self-employment tax. Furthermore, the corporation can deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders. However, the division between salary and dividends must be “reasonable” as determined by the IRS.

S Corporation Disadvantages

In order to be eligible to make the S Corp election and realize the tax benefits mentioned above, the corporation must meet strict operating requirements, which include the following: Only individuals, certain estates and trusts, and certain tax-exempt organizations can qualify to be an S Corporation shareholder. Each individual shareholder must be a U.S. citizen or resident. There cannot be more than 100 shareholders. There can only be one class of stock, which can make it difficult for startups that might be seeking funding or venture capital, since such relationships often depend upon the ability to create different categories of stock. While both C Corps and S Corps are allowed to provide employee benefits that are deductible by the corporation and tax-free to employees, the tax-free status of some fringe benefits is not nearly as generous for S Corp shareholders who own more than 2% of the corporation’s stock. S Corporations are not allowed to conduct certain kinds of business, such as banking, insurance companies taxed under Subchapter L, Domestic International Sales Corporations, and certain affiliated groups of corporations. C Corps can choose when their fiscal year ends, while an S Corp’s fiscal year end must be December 31st, which can be an issue for seasonal businesses. With S Corps, employee-owners cannot avoid paying payroll taxes by paying themselves nothing. The IRS requires owner-employees of an S Corp to be paid wages, and the salary received must be a “reasonable amount” for the work being performed. Generally, C Corps offer more flexibility than S Corps and are often the best choice for large companies with several shareholders, especially if they are publicly traded.

Conclusion

Electing to be treated as an S Corporation can offer several advantages to a company, but it is not the best choice for all. Be sure to consult with your company’s accountant and speak with a qualified Business Law Attorney to help you explore your options. Contact Attorney Stephen Kosa today at (715) 386-4125.