A corporation is an independent and legal entity, separate from its stakeholders or owners. It requires complying with more tax requirements and regulations. There are two types of corporations;
- C Corporation
- S Corporation
What Is an S Corporation?
The S Corp is a type of business entity that provides significant tax advantages while preserving ownership flexibility. It is also known as a small business corporation or subchapter. S Corp is a tax code that was enacted into law in 1958. The main purpose of S Corp is to support and encourage the idea of small businesses while cutting down the double taxation scheme.
Why Do You Need to Form an S Corporation?
When a business starts to grow and succeed in a well-established company, the tax rate tends to increase. Moreover, growing companies also face a variety of complexities, especially during tax season. Therefore, forming S Corporations or S Corp is important.
How Is an S Corp Better from A C Corp Or An LLC?
Unlike C Corporations (C Corps), the S Corporation does not involve corporate income taxes. Instead, it receives different treatment for taxation that is more favorable for the business owner. Moreover, similar to the LLC, S Corp is a pass-through entity for tax purposes. It means that the income earned or generated by an S Corporation will pass through to the shareholders’ income tax returns. In short, the S Corp itself does not owe any tax liability.
In addition, structuring your business as an S Corp also provides you the flexibility to manage your company’s ownership. The stock of S Corporations is freely transferable, unlike LLCs. This gives S Corporations; they can sell their ownership interest without getting approval from other shareholders.
How S Corporation Help You in Reducing the Tax Burden?
S Corporation can also help you save from paying additional taxes. One of the major concerns for business owners is to reduce their liability for self-employment taxes. The compensation of S Corporation shareholders is not subjected to profits but their self-employment tax.
This can minimize the overall tax burden by reducing your business profits that are subject to self-employment taxes. In short, depending on how your income appears on your personal tax return and how you pay yourself throughout the year, you can effectively manage your tax burden. For this, you can also consult your professional tax advisor or accountant to find you the best way to structure your business earnings for tax purposes.
What Are the Limitations of S Corporation?
Although S Corporation provides numerous tax advantages and ownership flexibility, it is still not suitable for every business type. There are a few limitations as well, which require to be followed.
- An S Corp must not have more than 100 shareholders. (https://www.incfile.com/what-is-s-corporation/)
- It must be a domestic business entity.
- All shareholders of the S Corporation must be legal residents of the United States.
- It is restricted to only one class of stock.
If you are a U.S.-based business and are satisfied to work within these limitations, then S Corporation can be a great choice for you. It will cause you to save a lot of money and avoid hassle as your company expands.
But if you have different business goals – for instance, if you want to have international shareholders or want your company to be publicly traded, then C Corporation might be a better choice for your business entity. Unlike S Corp, C Corporations does not have limitations on ownership and can also offer multiple stock classes.
How Can You Get S Corporation Status?
According to the IRS, a business should fulfill all of the following requirements to qualify for S Corporation status:
- It should be a domestic corporation.
- It should have only allowable shareholders, such as certain trusts, individuals, and estates.
- Shareholders must not include corporations, partnerships, or nonresidents.
- The company should not have more than 100 shareholders.
- It should only have one class of stock.
- The company should not be an ineligible corporation such as insurance companies, financial institutions, and domestic, international sales corporations.
- Finally, the corporation should also submit Form 2553 to have S Corporation status for tax purposes.
Advantages and Benefits of An S Corp
S Corporations has numerous benefits to offer if your company qualifies:
S Corporations are exempt from federal income tax except for passive income and individual capital gains. It allows the profit to pass to its shareholders, and the tax is applicable to each shareholder’s individual tax rates.
Due to the reason that S Corp is a pass-through entity, You have to pay taxes only once against the corporation’s profits . It means that S Corporations avoid having to pay “double taxation” of dividends. Therefore, if you want to save money with S Corporation, you should plan a strategic business name lookup.
Protection of Assets
S Corporation provides legal protection for your personal assets, which is separate from the business’s assets. Being a shareholder, you are not personally liable for the company’s liabilities or debts. If you have your personal assets protected, creditors will not be able to go after your personal assets to recover business debts.
Flexibility in Income Characterization
If you own S Corporation, you have the flexibility to characterize your income for tax purposes. Moreover, being a stakeholder or you can also become an employee of the business and pay yourself a salary.
Moreover, you can also pay yourself dividends from distributions that generally have a lower tax rate or are absolutely tax-free. It will help you reduce the self-employment tax liability until you characterize your dividends/distributions and salary reasonably.
Easy Transfer of Ownership
S Corporation makes it’s super easy and convenient to transfer ownership interests without involving any of the stakeholders, terminating the corporate entity, or causing significant tax consequences. Moreover, an S Corporation’s ownership transfer does not require compliance with complicated accounting rules or any property basis adjustments.
Drawbacks of An S Corporation
Besides offering numerous benefits, the S Corporation structure also possesses certain drawbacks or downsides and, therefore, not perfect for every business type.
Certain Restrictions Regarding Ownership
S Corporations do not have great flexibility in their ownership structure, unlike a C Corporation. Due to the fact that S Corps only entertain one class of stock, it limits the appeal to a variety of investors. In addition, the S Corp cannot have more than 100 shareholders and cannot be owned by any resident outside the US (foreign shareholders) and by other corporate entities or trust.
Risk in Income Characterization
S Corp has this brilliant feature of characterizing income as dividends or wages, but this flexibility can sometimes also present challenges. The IRS is always looking for business owners that are not fair in their money characterizations and payments of wages. Therefore, being an S Corporation owner, there is always a risk of re-characterizing a part of your income. it also causes you to pay higher taxes as a penalty.
Tax Qualification Mistakes
Being an S Corp owner, you should have sufficient knowledge on all the legal basics, and if you are not that capable, you should hire a professional advisor. However, this is a rare scenario, but S Corp owners sometimes make very common mistakes. These include the IRS’s inability to form filing requirements relevant to stock ownership, consent, election, notification, and other critical aspects of running an S Corp. All these mistakes can cause the company to lose its S Corporation status.
In short, everything has its pros and cons; in the end, you have to select the business module that suits your requirements, budget limits, and domain. However, the corporate structure is more expensive and complex than the other business structures, but it also provides many advantages over other business systems.
What Is Meant by Corporate Bylaws?
Corporate bylaws represent a detailed set of rules adopted by the board of directors of a company after it has been incorporated. It covers all the legal documents that a corporation needs to have in place as it designs its internal management structure and its execution procedures.
What Is an Operating Agreement?
It is a key document that outlines the financial and functional decisions, including provisions, rules, and business regulations. The purpose of this document is to govern all the business’s internal operations in a way that fulfills the specific needs of the business owners.
What Is LLC Membership Certificate?
It is a legal document that confirms LLC as an officially recognized legal entity in the state it was filed. If you have sub-branches of your business in several states, you need to file a separate certificate for each state.
How to File A Lawsuit?
If you want to file a lawsuit against any business or person you have a dispute with, you have to be someone affected directly by the legal dispute you are suing about. After this, you will search for an appropriate advocate for your case and fill the complaint form. This way, you can file a lawsuit to get justice.