When setting out to start a business, one needs to consider which type of business structure makes the most sense. Corporations (C-Corps), Limited Liability Companies (LLCs), and partnerships or sole proprietorships are some common business types that many people might be familiar with. S-Corp designation is a special type of tax treatment that qualifying businesses may apply for. The S in S Corp refers to Subchapter S in Chapter 1 of the Internal Revenue Service’s tax code. The IRS defines S Corps as corporations that elect to pass corporate income, losses, deductions, and credits to their shareholders for federal tax purposes. There can be a lot of confusion and misinformation around the S Corp designation, and understanding the pros and cons of an S Corp designation can help the business in the long run, and its benefits can often outweigh the disadvantages.

What type of business should I set up?

Sole proprietorships are some of the easiest business structures to set up. This structure essentially treats the business and the owner as a single entity, which means that creditors may be able to file claims for the personal assets of the owner to settle business debts and obligations. To avoid this risk and separate business and personal assets, many business owners choose to set up their businesses as Corporations or LLCs. Individual shareholders may, however, still be liable for debts or liabilities accrued by the business if they have offered personal guarantees.

In a Corporation or C Corp, the personal assets of owners and shareholders are protected from seizure to satisfy business liabilities. A C Corp’s earnings are subject to taxes at both the corporate and individual levels, essentially taxing shareholders twice on the earnings – once when the company earns the money, and again when dividends are paid out to the owner(s). However, unlike a C Corp, an S Corp designation allows individuals to avoid double taxation, with most or all of its income and losses being passed through to the company’s owners. This pass-through taxation means that the business doesn’t pay taxes at the corporate level, and any income or loss is reported on shareholders’ personal income tax returns. In a situation where the business experiences losses, owners can use this to offset other income they may have, reducing their income tax liability.

An LLC also allows for pass-through taxation, and the company’s business profits and losses are recorded with the owners’ personal income. LLCs also offer protection to the owners’ personal assets when it comes to settling the debts and obligations of the business. One of the big differences between an LLC and an S Corp is that an S Corp has the added benefit of being able to separate wages from dividends. In an LLC, any income that passes through the business entity to an owner is considered self-employment income by the IRS, which means Social Security and Medicare taxes are calculated on all earnings.

How much should I pay myself as an S Corp owner?

The IRS requires S Corp owners who are actively involved in running the business to receive a reasonable salary from the company. S Corp owners are generally classified as employees of the business and collect salaries in addition to dividends and distributions related to their investment in the company. While the Social Security and Medicare taxes still apply to the owners’ salaries, dividends are not subject to these taxes. With self-employment tax rates at 15.3% (12.4% for Social Security and 2.9% for Medicare), this could result in huge tax savings over time.

For example, the business may have a profit of $50,000. In an LLC, the entire $50,000 would be subject to the 15.3% self-employment tax. If the business has an S Corp designation, the owner could claim part of the profit, say $40,000, as their salary. The remaining $10,000 could then be issued as a dividend to the owner, free of payroll taxes (a savings of $1,530 over the LLC structure). It’s important to remember that dividends may not replace salaries, and owners should keep in mind that purposely paying themselves lower than normal salaries to avoid taxation can create some issues with the IRS. Using the previous example, taking a salary of $10,000 and a dividend payment of $40,000 may save significantly more in taxes, but it can be a surefire way to prompt an IRS investigation or audit.

Considerations for determining a reasonable wage can include the level of experience of each owner, their responsibilities, and the salaries of comparable positions in other companies. Dividends and distributions should be made from the profit remaining after wages are paid, and reported separately from the W-2 wages the owner earns as an employee of the business. (Dividends are reported on Schedule K-1.) Since S Corps receive the added tax benefit only on dividends, many businesses may choose to wait until the company’s income is substantial enough to make the designation worthwhile before electing S Corp status for their organization. Business owners should also note that reasonable salaries must be paid, even if the business is struggling with profitability.

An exception to the salary rule can be made for non-employee owners. Typically, non-employee owners are shareholders of the business who do not work in the day-to-day operations and perform little to no work in the business. In these cases, draws from the business and shareholder distributions are still allowed, but salary payments may not be required.

Pass-through taxation and other benefits of an S Corp designation may make this an attractive option for businesses that may have little to no startup costs or will turn relatively large profits in relation to business expenses. S Corps have some advantages when it comes to owners’ exit strategies as well. While the transfer or sale of a majority interest in an LLC may trigger complications, including termination of the entity, interests in an S Corp can be freely transferred with relative ease and without any major consequences.

How do I set up an S Corp?

A business owner wanting to form an S Corp can do so by preparing and filing of Articles of Incorporation or a Certificate of Incorporation with the proper authorities, to first establish the business as a Corporation or Limited Liability Company. Required information, fees, and taxes may vary from state to state. Then, the IRS requires the submission of form 2553 signed by all shareholders to elect S Corp status for the company. The election to be an S Corp must be made within a timeline specified by the IRS in order to take effect for a tax year. Exceptions may be made if the late election is due to reasonable cause.

Per the IRS, to qualify for S corporation status, there are several requirements that need to be met. The company should:

• Be a domestic corporation
• Have only allowable shareholders who:
  • May be individuals, certain trusts, and estates
  • May not be partnerships, corporations, or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

A formal organizational meeting should be held and recorded to adopt bylaws, appoint officers, and perform other corporate actions. The requirements for formal meetings and record-keeping in an S Corp can add to the administrative burden of running the business and might deter people from setting up their company this way but there may be an option for an LLC with an S Corp election. This gives owners the ease of administration that comes with an LLC, while still allowing for the tax advantages that come with the S Corp status.

Even though an S Corp may not need to pay tax on its business profits, it is still recognized as a separate entity from its owners, and the company is still required to file an annual tax return. S Corp filers will need to complete Form 1120S, U.S. Income Tax Return for an S Corporation which includes information on the S Corp’s income, deductions, and payment activity. S Corps are also required to distribute Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc. to each shareholder. Schedule K-1 provides each shareholder with details with their respective share of the company’s income. This is separate from the W-2 that needs to be reported and filed for each employee of the company.

Different states may have different rules for S Corps when it comes to taxes and reporting requirements, with many states often requiring at least the filing of informational returns. Although the business may not be taxed by the federal government, individual states might require taxation. In other states, S Corps may be assessed a flat fee instead.

There are additional rules for S Corp owners – specifically, for those who the IRS considers 2% shareholders. Any person who owns at least 2% of the S Corp at any point in the year is considered a 2% shareholder, and this low threshold makes it highly likely that most business owners of S Corps will be classified in this manner.

Under the 2% shareholder rule, premium payments made for health or accident insurance for these individuals are required to be treated as shareholder compensation and need to be included in their W-2 wages for federal income tax in box 1. Premium payments amounts should not be recorded in boxes 3 or 5 for FICA taxes. In other words, health insurance premiums for 2% owners of S Corps do not qualify for pre-tax treatment, though owners may be able to take a deduction for their health plan when filing form 1040 for their annual personal tax return.

Disadvantages of an S Corp election

Depending on each company’s situation, becoming an S Corp can have its disadvantages, too. As previously mentioned, the IRS has several requirements that must be met in order to qualify for S Corp status, some of which may be restrictive or difficult for a business to comply with. Large or fast-growing companies might find it more beneficial to go with a C Corporation structure, which allows for multiple classes of stock to be issued and does not place limits on the type or number of shareholders in the company. C Corps are often the preferred structure for businesses that want to get investments and funding from venture capitalists or have goals of eventually becoming a publicly-traded company.

Smaller businesses might also find the S Corp’s more formal requirements too burdensome and not worth the headache. Scheduled, formal meetings of directors and shareholders, maintenance of meeting minutes, and other recordkeeping requirements may be seen as more trouble than they’re worth. Shareholders of an S Corp report profits and losses that are proportional to the number of shares they own, but business owners might want to allocate specific percentages of ownership to different partners, sometimes with allocations changing over time. For these companies, a partnership or LLC can be a more attractive option.

While the S Corp designation allows for a bit of flexibility when it comes to the owners being able to split earnings between wages and dividends, they must be careful about how the amounts are being split. The IRS may scrutinize the amounts that are being characterized as wages vs. dividends and may require re-categorizing the income in different ways, which could lead to higher than expected tax liabilities. Incorrect filing of certain aspects of the S Corp with the IRS can also cause the company’s S Corp status to be revoked, which could result in penalties, back taxes, and a waiting period before the business is able to regain its S Corp designation.

In summary…

There are many reasons why an S Corp might be the best structure for your business, including the advantage of pass-through taxation when it comes to earnings, protecting personal assets, and the ability to freely transfer ownership of shares of the company. However, the choice to elect an S Corp designation for a business can be complicated and is not always a one size fits all solution. The decision will depend on the organization’s overall goals, size, and other factors, including the company’s willingness to comply with all of the added requirements that come with the S Corp designation. Business owners should consult with their attorneys, tax consultants, and other shareholders (remember, all shareholders must agree to the decision) to choose the structure that works best for the company.