The Basics of an S Corporation
When you are thinking of forming your business, you will probably hear about an S corporation and wonder how it differs from any other type of corporation. Unlike an LLC or partnership, an S Corporation is not its own unique type of entity. It is actually a type of tax election a small corporation or an LLC can choose to take. The “S” comes from Subchapter S in the U.S. tax code. If you have decided to turn your small business into a formal entity, you should discuss the benefits and disadvantages of a corporation, LLC, and S Corporation with an experienced West Palm Beach business formation attorney as soon as possible.
What is an S Corp?
An S Corporation is a corporation that has chosen to take a special IRS tax election to avoid the traditional double taxation of a corporation. Under this tax election, the profits or losses of the corporation pass through to the shareholders and are recorded on each shareholder’s personal tax return. The profits and losses are not first taxed as corporate income and then taxed again if paid to the shareholders as dividends. The pass through nature of the S Corporation makes the taxation of the corporation more like a sole proprietorship or a partnership.
Taking this tax election can also be advantageous when the personal income tax rate is lower than the corporate tax rate. This is particularly true in Florida where there is no state personal income tax. When your S Corporation profits pass through to you as personal income, you do not pay state income taxes on it. If the funds were corporate profits, they would be subject to state corporate income tax.
When Does a Corporation Qualify for an S Election?
Not every corporation is eligible to take this tax election. A corporation must first review the IRS standards. In general, large corporations and certain types of financial institutions do not qualify.
To take this tax election, your corporation must:
- Be domestic;
- Have fewer than 100 shareholders;
- Have allowable shareholders, which include individuals and some trusts or estates, but not partnerships or corporate shareholders;
- Have one class of stock; and
- Not be an ineligible type of corporation, such as an insurance company.
S Corporation elections are usually taken by closely held corporations, which means there are only a handful of individual shareholders who participate and profit from the business. If your business is eligible for an S Corporation election, you must file Form 2553 within 2 months and 15 days of the beginning of the tax year or at any time for it to go into effect for the next tax year.
Disadvantages to S Corps
This may sound like the perfect type of legal entity for your business, but there are some disadvantages. Unlike an LLC, an S Corporation must still follow strict corporate governance rules. The structure of a corporation is already defined and must follow annual meetings and record-keeping regulations.
There is little to no flexibility in defining different types of voting rights or allocating profits and losses differently among shareholders. A traditional corporation can have some flexibility because it can create different shares of stock, which have different rights to voting, profits, and losses. However, an S Corporation can only have one type of stock, so everyone shares in profits and losses the same and every shareholder gets a vote.
Another disadvantage is that if one of the shareholders works for the corporation, he or she must be paid reasonable compensation. If the IRS believes you or another shareholder are paid too much or too little for the work you perform for the company, then the IRS can requalify your wages, and you could end up paying more in taxes.
If you have questions about the pros and cons of taking an S Corporation election, contact The Law Offices of Larry E. Bray, P.A. at 561-571-8970. We are eager to assist you throughout each step of your case.