“Should we form an S corporation (frequently referred to as an “S Corp”) or a limited liability company (“LLC”)?” I am asked at least once a week – and to be perfectly honest… it is a fantastic question that I wish I were asked more often.
I wish this question were asked more often, because, when entrepreneurs look to form a small business, the decisions of these future business owners can have long lasting effects. One of these decisions is the decision of how to best structure a new business.
While, as a future business owner, you have many choices in terms of legal structure, ranging from a sole proprietorship to corporation status (and many in between), choosing the right legal structure is an often overlooked decision with the potential to have enormous consequences.
As I initially alluded, two of the most common business entities chosen by entrepreneurs are the S corporation and the limited liability company. And while we will later have an entirely serrate post on limited liability companies, we thought it first important to tackle the S Corp – as sometimes it is a little less known than its LLC counterpart.
What is an S Corporation?
An S corporation is actually not a separate entity in itself. Rather, it is a corporation has received a special IRS designation, enabling certain tax protections. As Entrepreneur puts it, in an S corp structure, “income and losses are passed through to shareholders [owners] and included on their individual tax returns. As a result, there's just one level of federal tax to pay.”
An S Corp’s profits and losses are taxed once, at the individual’s—the owner’s—tax rate. The S Corp itself has zero tax liability on profits or losses. (This differs from the traditional corporation (also known as a C corporation or “C Corp” for short) designation in which the business pays taxes on profits and the owner also pays taxes, on salary and dividends.)
Additionally, while some companies might benefit from being a regular C Corp due to the possibility of later reaching significant financial success, there is no need to forgo registering as an S Corp because of this. If you register as an S Corp and that day later arrives for your company, it is possible to switch between an S Corp to a C Corp.
Requirements to Form an S Corporation
- Corporation: The first step is to form the corporation. While this can vary from state to state, generally a corporation is formed upon the filing of Articles of Incorporation with the Secretary of State where you want to form your corporation.
- IRS 2553: The second step requires the owner(s) of the corporation filling form 2553 with the Internal Revenue Service. This form is titled “Election by a Small Business Corporation”.
- Timing: You will need to choose the S Corp designation early. There is a 45-day deadline when forming an S Corp and if you miss it, you might be out of luck.
- Ownership: The IRS limits the number of owners/shareholders to 100. Owners are limited to individuals (must be legal residents of the United States), certain trusts, and estates.
- Shares: When setting up shares for your corporation, if you want to become an S Corp, you may only have one class of stock in proportion to each shareholder's interest in the business.
S Corporation Advantages
- Tax savings are the reason most entrepreneurs choose the S Corp status. Owners report and pay taxes on only their share of company profits and losses at their individual tax rates. As for the business itself, as the Small Business Administration (an excellent resource) points out, “…only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a ‘distribution,’ which is taxed at a lower rate, if at all.”
- Only annual tax filings are required. C Corps require quarterly filings. As a small business owner, consider how you prefer spending your time.
- Limited liability protection is extended to owners and employees.
- Need more capital? An S Corp status allows your company to take on new investors.
- The forever factor: the S Corp status lives on regardless of changes in ownership.
S Corporation Disadvantages
- S Corp shareholders’ deductions are limited to corporate losses that total less than the amount of the shareholder's investment. In other words, if your investment is $25,000, you may deduct up to that amount in losses.
- Similar to C Corps, an S Corp must develop by-laws, and host regular director and shareholder minuted meetings. Allow for the costs and maintenance of these proceedings.
- Other corporate fees may apply—check with your Secretary of State’s corporate division for information on annual fees.
- If an employee of an S Corp owns more than 2 percent of company shares, then company benefits (such as healthcare insurance) may be taxable.
- With an S Corp, a shareholder must receive reasonable compensation. If a shareholder takes low salary/high distribution combinations, the IRS may take notice and may reclassify your distributions as wages.
Creating a new enterprise is exciting—and selecting the most appropriate legal status for your situation carries financial impacts you want to get right. We at Cordero Law LLC are happy to assist you as you take this key step. Please contact us to see how we can help.
Julian Cordero is an Attorney, Music Producer, and Entrepreneur. Oh and he blogs too! Julian is licensed to practice law in New York and is the Managing Member of Cordero Law LLC, a New York City based law firm focusing on Business Law, Entertainment Law, and Intellectual Property.