An important choice that all business owners make is how to classify their business. There are a number of different business entities to choose from, such as Limited Liability Companies (LLCs), Sole Proprietorships, and S-Corporations. 

S-Corporations are a flexible option for an individual or shareholders to create a corporation. Its structure allows shareholders to avoid certain taxes and save money. This corporation type also offers helpful protections including pass-through status and limited liability. Shareholders play an essential part in the development and growth of S-Corps. Consider the following benefits and drawbacks of an S-Corp. 

What Is an S-Corp? 

For your business to become an S-Corp, your business must:

  • Be a domestic corporation 
  • Have only allowable shareholders such as certain trusts, estates, and individuals 
  • Have no more than 100 shareholders 
  • Have only one class of stock 

The following types of corporations are ineligible:

  • Certain financial institutions
  • Insurance companies
  • Non-US corporations 

To register your business as an S-Corp, you must submit Form 2253, Election by a Small Business Corporation, signed by all the shareholders. 

What Are the Benefits of an S-Corp? 

There are several benefits to consider if you’re interested in forming an S-Corp. First, your business will have pass-through status. You’ll only pay taxes on money earned from your company, not taxes for your business itself.  

Second, shareholders of S-Corps have limited liability. Shareholders are not personally liable for the actions of the company. Their personal assets remain separate from any assets that the S-Corp has. 

The third benefit of S-Corporations is taxation. Profits and losses in an S-Corp pass through to stakeholders. That means that you’ll pay taxes once instead of being charged for the profits that the corporation earns.

Finally, S-Corps owners pay lower costs for Medicare and Social Security. Owners of corporations who are also employees are not responsible for these taxes. Instead, they only pay taxes based on their compensation.

Can You Pay Yourself a Salary in an S-Corp? 

S-Corp owners must pay themselves a reasonable salary. A “reasonable salary” can vary, but it is the equivalent of what employees in your industry earn for similar work. To determine a reasonable salary for yourself and your shareholders, think about: 

  • Compensation agreements 
  • Dividend history 
  • Duties and responsibilities 
  • Payments to non-shareholder employees 
  • Time and effort devoted to the business 
  • Training and experience
  • What comparable business pay for similar services

What Are the Downsides to an S-Corp?

There are a few downsides to consider if you’re interested in an S-Corp. First, S-Corporations are required to file both federal and state taxes. This includes Articles of Incorporation and corporate minutes. You’ll also hold regular shareholder meetings and pay required government fees if you form an S-Corp. 

There are also shareholder restrictions to consider. Shareholders pay taxes on income that the S-Corp receives, even if the shareholder didn’t receive any of the revenue. Finally, the IRS requires officers and owners of S-Corps to make a salary, even if the company has yet to make a profit. 

What Else Should I Know? 

As an S-Corp, your corporation can avoid double taxation. S-Corps are pass-through tax entities, meaning that the corporation isn’t taxed on its profits. Profits passed onto shareholders are taxed as personal income.

Shareholders can receive dividends – the remaining profits after paying expenses. Shareholders do not have to pay a self-employment tax on these earnings.

Since S-Corp shareholders are employees, any earnings are subject to the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA). You must withhold some of your income for federal income taxes and report any earnings on your and the shareholders’ personal income tax.

It is possible to operate an S-Corp as an independent contractor instead of an employee. If this is the case for you, you’ll fill out a W-9 and pay a self-employment tax of 15.3%.

Finally, to form your S-Corp, you’ll need to:  

  • Some Secretaries of State work with S-Corps. If your state does, choose a legal name and reserve it through the state. 
  • Draft and file Articles of Incorporation with your Secretary of State
  • Issue stock certificates to initial shareholders
  • Apply for all certificates and licenses relevant to your corporation
  • File for a Form SS-4 (Application for Employer Identification Number) with the IRS to obtain an EIN
  • Apply for any other ID numbers that your local government and state require
  • Complete and submit Form 2553 (Election by a Small Business Corporation) within 75 days of forming your S-Corp

Work with the Professionals

S-Corps offer advantages to owners and shareholders that ensure success. While beneficial, the process can lead to confusion, and you may need answers or clarification. It may be helpful to work with an accounting professional if you are unsure of the S-Corp application and formation process. An accountant will assist you through the S-Corp process. Don’t hesitate to seek advice from the experts to guide your corporation through this global crisis.

 

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Written by Rudy Robles

Rudy Robles is the Bookkeeping and Payroll Supervisor for the Eastern Team at 1-800Accountant. Prior to 1-800Accountant, he's worked in vari...