In the United States, there are four key types of business formations. Typically, businesses tend to be organized as corporations, sole proprietorships, limited liability companies (LLCs), or partnerships. However, there are also subtypes within each of these categories.
After sole proprietorships, S corporations are the most common type of business formation. Today, 13.1% of American businesses are S corps. Although there are a few drawbacks to having an S corporation, there are many tax advantages that small business owners can enjoy. Learn more about this type of business structure to determine if an S corporation is right for you.
What Is an S Corp?
At its heart, an S corp is a type of pass-through entity. When money is earned, the profits or losses get passed through to the owners of the business. While this confers a number of important advantages, there are also some limitations. For instance, S corporations must be owned by a foreign individual, and there can never be more than 100 shareholders.
In a recent Mission to Grow episode on “Entity Classification: Exploring the Benefits and Risks of S Corps,” Jason Blumer, CEO of Blummer & Associates, discussed when it makes sense to set up an S corporation. According to Blumer, “If you are on a mission to grow as an entrepreneur, there are some entities you shouldn’t do that in. An S corp is one you can grow in. It is perfect for small businesses.”
The Benefits of Creating an S Corp
By deciding to incorporate your business, you can protect your assets, save money on taxes, and open up potential financing possibilities. While an S corp isn’t the right choice for every business, it can be a lucrative alternative. Once you hit $80,000 to $100,000 in business profits, switching to an S corp structure will start saving you a significant amount of money.
Pass-Through Taxation
One of the reasons why an S corp is preferable to a C corp is because it allows for pass-through taxation. With a C corporation, company profits and shareholder distributions both end up getting taxed. Other than passive income and very select circumstances, an S corp’s profits aren’t taxed at a federal level. Additionally, most states also do not tax S corporations.
Instead, the profits and losses are passed onto the shareholders. During the company’s start-up phase, these losses can significantly lower your personal tax burden.
Lower Self-Employment Taxes
Normally, sole proprietors have to pay 15.3% in self-employment taxes. This is because they are paying the employee’s 7.65% share as well as the employer’s 7.65% portion of Social Security and Medicare taxes. If your small business earns $100,000 in profits, you would have to pay $15,300 in self-employment taxes.
Fortunately, this isn’t the case if you have an S corp. With an S corporation, you simply pay the self-employment tax on the salary you draw. You don’t have to pay any self-employment taxes on the owner distribution you receive from your profits.
Limited Liability Protection
Like an LLC, an S corporation provides owner liability protection. This means that the owner isn’t personally responsible for debts incurred by the business. To receive these protections, you must make sure your company fulfills all of its compliance requirements as an S corporation.
More Financing Possibilities
Once you incorporate as an S corp, you open your small business up to new financing options. For example, an S corp is legally allowed to sell shares of company stock. This option allows you an additional means of raising capital.
However, it’s important to keep in mind that S corps are only allowed to sell a single type of share. You aren’t allowed to sell preferred stock, common stock, and other forms of stock at the same time.
Enhanced Credibility
Among your customers, employees, vendors, and strategic partners, you can gain credibility by becoming an S corp. An S corporation gives you added prestige, and it demonstrates that you are more serious about operating your business. In turn, this added prestige and credibility can help your company grow.
Easy Transfer of Ownership
When you have your business set up as an S corp, it makes transferring ownership much easier. Instead of having to worry about tax ramifications, you can simply transfer the ownership to someone else. S corporations are also a useful business structure because they can continue after you die. An S corp can be taken over by an heir or sold to an interested party for the benefit of your estate.
The Risks of Creating an S Corp
Although there are some distinct benefits involved in creating an S corp, you must consider the risks with care. If you are uncertain about whether this business structure is right for you, it’s a good idea to talk to your lawyer, an accountant, or a similar business professional to get a better understanding of the advantages and disadvantages.
Administrative Costs
According to Blumer, there are times when “you can get a profit that’s low enough that it wouldn’t be valuable to the client.” As a general rule of thumb, your business needs to earn at least $80,000 to $100,000 in profits a year before transitioning to an S corp makes sense. You’ll need to pay filing fees with your state to set up your S corp. After it’s set up, you’ll have administrative costs, such as paying your payroll provider.
While these costs aren’t significant, they can add up over time. If you are a sole proprietor who earns $100,000 in profits, you are paying $15,300 in self-employment taxes. As an S corp, you could pay yourself a salary of $60,000 and receive an owner distribution for $40,000. You wouldn’t have to pay that 15.3% tax on the $40,000, saving you $6,120 in taxes.
If your business earns half as much per year, you might only save $3,000. After the added administrative costs, filing fees, and associated expenses, setting up an S corp might not be worth the effort.
Specific Eligibility Requirements
To set up an S corp, you must meet certain eligibility requirements. For instance, you cannot be a foreigner because S corporations can only have domestic owners. If you sell a portion of the S corp to a foreign owner unintentionally, the IRS will “go back and find out the very date you made them an owner and take your S corp election away. If the IRS doesn’t catch up to you for another three years and there’s three years you’ve been filing S Corp returns with a non-allowed owner, they’ll go back and restate three years ago,” Blumer says.
Similarly, S corporations only allow shares to be issued if they are all the same. You can’t have common and preferred stock. Unfortunately, you could easily end up violating this rule if you end up treating a new owner differently than you treat yourself.
Possibility of Losing S Corp Status
Whenever you set up an S corp, there is always a risk that you could end up losing it. Your S corp status can be terminated if you report having a non-allowable shareholder or file returns with too many owner distributions. Additionally, you may lose your S corp status if you have more passive income or retained earnings than you are supposed to.
Strict Allocation of Your Profits and Losses
As a S corp, you are required to allocate your profits and losses to your shareholders. In comparison, partnerships or LLCs taxed like partnerships let you create your own agreements about how profits and losses will be allocated. With an S corp, someone who owns 25% of the company must receive 25% of your losses or profits.
Is an S Corp Right for You?
From limitations on the number of shareholders to rules about having one class of stock, there are specific regulations for how S corporations are formed and operated. Because of this, an S corp may not be the best decision for everyone. If you’re interested in long-term growth and lower tax obligations, setting up an S corporation may be the best choice.
To learn more about the advantages of transitioning your small business to an S corp structure, reach out to Asure’s team of small business payroll and HR experts today.