5 Things to Know About S-Corporations
Setting up a new business brings forward a lot of questions – finding the right vendors, selecting the right business model, deciding who to hire, understanding your payroll schedule – but before you can even start thinking about these day-to-day elements of business, you have to decide how you’re going to structure your business.
While not the most exciting of subjects, the corporate structure is a critical decision, as it can affect all aspects of your business. This is especially true with regards to S-Corporations, or S-Corps or S-Subchapters. While this corporate structure may be less common than LLCs or C-Corps, it is a popular choice for small business owners primarily due to the tax benefits and legal protection it offers its shareholders. Read on to learn more about S-Corps and why they may be a good fit for your new business.
What is an S-Corp?
The Internal Revenue Service defines S-Corporations as: “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S-Corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their personal income tax rates.” Because of this method of reporting income, S-Corps can avoid double taxation on their corporate income, while still being responsible for some taxes at the entity level.
To qualify for S-Corp status, the business must meet the following requirements:
- Be domiciled in the United States
- Have only allowable shareholders (not to exceed 100)
- May be include individuals, certain trusts and estates,
- May not include partnerships, corporations, or non-resident alien shareholders.
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies and domestic international sales corporations).
- Must submit for 2553 Election by a Small Business Corporation, signed by all shareholders.
What Taxes are S-Corps Liable For?
As Benjamin Franklin stated, “In this world nothing can be said to be certain except death and taxes.” While taxes may look slightly different compared to an LLC or C-Corp, S-Corps are still liable for the following:
- Income Tax. In a regular corporation, income is subject to ‘double taxation,’ first at the corporate level, then for an individual’s income tax. Conversely, according to the IRS, “an S-Corporation is exempt from federal income tax other than tax on certain capital gains and passive income. It is treated in the same way as a partnership, in that generally taxes are not paid at the corporate level”. So rather than facing the dreaded ‘double tax’, all corporate income, losses, credits and deductions flow through the shareholders who simply report it on their personal tax returns and are taxed at their individual income tax rate. There are exceptions to this rule, so check with your local tax code or consult with an accountant or bookkeeper before filing.
- Estimated Taxes. If the amount of income tax withheld from your salary or pension is not sufficient, or if you receive income in the form of interest, dividends, alimony, self-employment income, capital gains, prizes or awards, you may need to supplement your income tax with estimated tax payments. This is especially true if you work for yourself – estimated taxes are used to pay not only income tax, but also other taxes such as self-employment tax and alternative minimum tax. Failure to account for these payments may result in a penalty. S-corporation shareholders typically have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed. To calculate your estimated tax dues and pay them, complete Form 1040-ES for individuals or Form 1120-W for corporations.
- Employment Taxes. In addition to their income tax, S-Corps are still required to pay standard employment taxes, including Social Security and Medicare (also known as FICA) axes and Federal Unemployment taxes (FUTA).
Benefits of an S-Corp Structure
Structuring your business as an S-Corp may be beneficial to your firm for the following reasons:
- Self-Employment Tax. Choosing an S-Corp structure for your business has several benefits to small business owners. In addition to skipping the aforementioned ‘double taxation’ issue, the S-Corp structure may also lower the self-employment tax, as the taxable business income is split into two components – salary and distribution. This means that the self-employment tax only applies to the salary component, reducing the amount of taxes due.
- Independent Life and Transfer of Ownership. An S-Corp has an independent lifespan, not dependent on its shareholders. This makes it easier to plan for long-term growth at the firm, as shareholders can come and go without impacting the business. This is different from LLCs or sole proprietorships, in which the life of the business depends on the owner’s life or their exit from the business. Additionally, the transfer of ownership is typically easier than in other structures. The sale of the business can happen immediately or gradually and is facilitated through a written sales agreement.
- Additional Protection. Because shareholders’ personal assets are protected by the S-Corp structure, shareholders are not personally responsible for the business’ debts and liabilities. This means that creditors cannot access the shareholders’ personal assets as a way of settling debts with the business.
Disadvantages of an S-Corp Structure
If everything you’ve read so far seems appealing, be aware there are some disadvantages to an S-Corp structure:
- Restrictions, Restrictions, Restrictions. S-Corps are subject to more restrictions from the IRS than many other corporate structures. For example, all shareholders are required to be U.S. citizens or permanent residents, and transfer of ownership can only be done to certain individuals, estates or trusts. Additionally, allocation of income and losses is based on the percentage of ownership and cannot be modified in an operating agreement like an LLC. Finally, making sudden changes to someone’s salary/distribution ratio can raise suspicion with the IRS, resulting in higher taxes or an audit.
- Protocols and Paperwork. S-Corps are also required to follow a number of strict protocols, including scheduled meetings of directors and shareholders, formalized by-laws, maintenance of records, and keeping comprehensive meeting minutes. This is because the IRS tends to scrutinize S-Corps more heavily than an LLC to ensure they’re not violating tax laws and are paying an appropriate amount of taxes, so accurate record-keeping is vital in case an S-Corp were to be audited. Because of the extra reporting S-Corps require, it may be a good idea to work with an accountant or bookkeeper to ensure your business doesn’t end up on the IRS’ watch list.
How S-Corps Affect Payroll
- “Reasonable Salary” Rules. As you may have figured out by now, an S-Corp can be a great way for a small business owner to save money by giving them a break on taxes. While splitting up your businesses’ profits between your salary and shareholder distributions may save you from double taxation, it’s important to keep in mind that there are restrictions to how much can go into which bucket. The IRS requires that S-Corp shareholder employees are required to pay themselves a ‘reasonable salary’, equating to what a similar role would be paid at another company. Dropping too much money in the wrong bucket could end up costing you more than that in fines if your small business were to get audited.
- Health Insurance. In most cases, employee health insurance is a non-taxable fringe benefit. However, S-Corps are slightly different: if owners or shareholders own more than 2% of the company’s stock, the cost they pay for their health insurance is subject to income tax. Therefore, you will need to include the amount of the S-Corp shareholder health insurance premium in those shareholders’ taxable wages. It is critically important that this information is recorded in your payroll account by year-end, so it’s best not to wait until the last minute.
As you can see, choosing an S-Corp structure for your small business could be a smart decision, but it’s certainly not a fit for every employer. Understanding the benefits and downfalls of each corporate structure is vital for the health and success of your business, and knowing how they impact everyday items like payroll can keep you from making costly payroll mistakes. If you’re unsure about what structure works best for you, it’s a good idea to consult with an accountant or financial advisor, as they’ll be able to guide you towards the right structure for your business.
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This website contains articles posted for informational and educational value. SurePayroll is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, SurePayroll. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant. If you require legal or accounting advice or need other professional assistance, you should always consult your licensed attorney, accountant or other tax professional to discuss your particular facts, circumstances and business needs.