Best Legal Structure for My Business: S-Corp

What is an S-Corp?

It can be exciting to watch a small business grow, but growth within your business can mean growth of your tax rate, too. As a small business achieves success and reaches important milestones in its development,  taxes can become increasingly more difficult to navigate. It is for this reason that some may consider forming an S-Corporation (or S-Corp) to provide tax advantages and preserve ownership flexibility. 

An S-Corp is a tax designation that is available to certain corporations and LLCs. They are named for the subchapter “S” of the IRS and are characterized by a “pass-through” tax structure. It was designed to support the formation of small businesses by eliminating the double taxation that conventional corporations are subject to. 

Advantages of an S-Corp 

Tax Advantages

According to the IRS, S-Corps pass their corporate income, losses, deductions, and credits to shareholders for federal tax purposes. This means that S-Corps are exempt from federal corporate income tax, except for certain capital gains and passive income. Instead, profit is passed through to the shareholders, where it is then taxed at the individual (usually lower) level. This “pass-through” ensures that profit is  only taxed once – at the shareholder level – and the corporation can avoid double taxation of their dividends. 

Asset Protection / Liability Protection

S-Corps provide the same protection from liability that is offered by corporation status. This means that business owners’ or shareholders’ personal assets are separate from the assets of the business. In this case, shareholders are not personally responsible for the company’s debts or liabilities, and creditors are not typically able to pursue shareholders’ personal assets in order to recuperate business debts. 

Flexible Characterization of Income

S-Corps give business owners flexibility in how they characterize their income on their taxes. Owners and shareholders can pay themselves a salary from their business, but may also pay themselves dividends that are predominantly tax-free or taxed at a lower rate than salary. As long as the salary and dividends are characterized in an appropriate manner, this can help lower the business owner’s self-employment liability. 

Relatively Easy Transfer of Ownership

S-Corps are independent from the business owner. This means that the exit of a key shareholder will not create an overwhelming hindrance to the continuance of the entity. S-Corp ownership interests can be transferred to other owners without significant tax consequences, and transfer of ownership, whether through outright or gradual sale, can be completed relatively smoothly. 

Disadvantages of an S-Corp

The S-Corp structure may not be right for every business, as there are situations  which may disqualify or disincentivize a business from seeking the benefits an S-Corp can offer. 

Ownership Restrictions

S-Corp ownership is restricted primarily to individuals who are citizens or permanent residents of the U.S., ruling out ownership by other corporations and partnerships. S-Corps cannot exceed more than 100 shareholders, effectively excluding any corporations with the goal of going public. S-Corps can only offer one class of stock, which may discourage certain investors. 

Wages and Dividends 

S-Corps provide flexibility in characterizing income as wages or dividends, but they may also receive extra scrutiny from the IRS because of this. The IRS is vigilant about checking the allocation of income; the IRS does not want to see artificially low salaries in order to avoid paying the self-employment taxes on dividends. Salaries paid to S-Corp shareholders must be reasonable, or the risk increases of being required to re-characterize income and pay higher taxes. 

Requirements for S-Corp

According to the IRS, to qualify for S-Corporation status, a business must meet these requirements:

1. Be a domestic corporation
2. Have only allowable shareholders – which may include individuals, certain trusts, and estates, but not partnerships, corporations or nonresident alien shareholders
3. Have only one class of stock
4. Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

Which Legal Structure is Best for My Business? 

Although they have many desirable characteristics, S-corps are only one of many possible business structure designations, including C-Corps, LLCs, Sole Proprietorships, and Partnerships, all of which will be addressed in presentations to follow. The best choice for your business depends on many factors. If you’re unsure of which business structure is best for you, consult a business attorney for advice. It is critical to remember that what affects one type of business will not necessarily have equal or any impact for another. So understanding your aspirations in context is critical.

Steinberg Law can help examine current needs and future business aspirations, help you weigh your options, make the most informed decision, and create a customized plan for your business.