by Choosing the right business structure for your enterprise is a crucial decision. It has long-lasting ramifications, as it sets the path for the future in terms of operations, management, legal, and tax issues. Proper research should be done before you take your pick.
There are several organizational forms that businesses can choose from, including sole proprietorship, partnership, limited liability company (LLC), corporation, or an S corporation.
S Corporation is a variation of a corporation within Subchapter S of Chapter 1 of the Internal Revenue Code. Essentially, an S corp is any business that chooses to pass corporate income, losses, deductions, and credit through shareholders for federal tax purposes, with the benefit of limited liability and relief from “double taxation.” Some 30 million business owners include business profits on their personal income tax returns.
To be an S Corporation, your business first needs to be set up as a corporation by filling and submitting documents like the Articles of Incorporation or Certificate of incorporation to the appropriate government authority, along with the applicable fee.
Once the incorporation process is complete, all shareholders must sign and submit Form 2553 to be granted the S Corporation designation. From there, taxes are handled by the corporation’s partners on their individual returns.
To qualify:
- Shareholders may only be individuals, certain trusts, estates, and certain exempt organizations (such as a 501(c)(3) nonprofit). Shareholders may not be partnerships or corporations.
- Shareholders must be US citizens or residents.
- The business may have no more than 100 shareholders.
- The business may only have one class of stock (if stock is issued).
- The business profits and losses may only be allocated in proportion to each owner’s interest in the business.
- The business must not be an “ineligible corporation” such as an insurance company subject to subchapter L, domestic international sales corporation (DISC), or possession corporation under section 585.
- All shareholders must consent to the election.
According to Internal Revenue Service (IRS), to qualify for S corporation status, the corporation must meet the following requirements:
- Be domiciled in the United States
- Have only allowable shareholders, which may include individuals, certain trusts, and estates, and cannot include partnerships, corporations, or non-resident alien shareholders
- Have 100 or fewer shareholders
- Have just one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations, which are forbidden the S corp structure)
More Advantages of an S-Corp Structure
Independent Life
Unlike a sole proprietorship or LLC (LLC without necessary inclusions in its operating agreement) where the life of the business is linked to the owner’s life or exit from business, an S Corporation has an independent life span. Its longevity is not dependent on shareholders, whether they depart or stay, thus making it relatively easy to do business and look at long-term goals and growth.
Self-Employment Tax
Employing an S Corporation structure can lower the self-employment tax. The taxable business income can be split into two components salary and distribution. Here, only the salary component attracts the self-employment tax, thus reducing the overall tax liability. While in the case of a sole proprietorship, partnership, or LLC, the self-employment tax is applicable on the entire net business income.
The second component of the income comes to the shareholder (owner) as distribution, which is not taxed. By making a “reasonable” division between the two components, there can be a substantial amount of tax savings. It’s considered good to draw approximately 60% of the company’s income as salary since any unreasonable division could be construed as an attempt to avoid taxes.
Protective Shield
Personal assets of shareholders are protected by the structure of an S Corp. No shareholder is personally responsible for the liabilities and debts of the business. Creditors have no claim on the personal assets of shareholders in order to settle business debt, whereas personal assets are vulnerable under sole proprietorships or partnerships.
Transfer of Ownership
It’s relatively easy to transfer interest in an S Corporation as compared to other forms of business entities. The sale can be structured in two ways:
- An outright sale, where the buyer makes the purchase in one go and there is an immediate transfer of ownership.
- A gradual sale, where the purchase is done over a period of time. Whichever way is chosen, the transfer of ownership is facilitated through a written sales agreement that formalizes the whole process.
