When new companies start, one of the first decisions they make is the form of entity the new business will take. Often the choice comes down between a corporation and an LLC. Because corporations have double taxation, if the corporate entity is chosen, the new business owner often wants to make an S corporation election so that double taxation does not apply. Many think that the S Corp election gives the best of both worlds—an actual corporate form with its limit liability characteristics, and pass through taxation. However, this article will dispel some of the myths about this too-good-to-be-true entity election. While it can be great for many business owners, as with all entities, it has its pros and cons.
Special Characteristics
One big misconception is that an S Corporation is the same as a standard C Corporation but simply has pass through taxation. That is not correct. Before one can make the election to be an S Corp, they must meet certain requirements:
- It has a maximum of 100 shareholders
- There can be only one class of stock
- All shareholders must be US citizens or resident aliens
- Generally, shareholders must be natural persons and cannot be entities (Some exceptions for trusts and other entities may apply).
With those requirements it can already be seen that an S Corporation does not have all of the “corporate” advantages as a true C Corp. However, with any entity form, there are advantages and disadvantages.
Some Advantages
- Losses flow through to individual shareholders
- Pass through taxation
- S Corporations are not subject to corporate alternative minimum tax
- Accumulated earnings taxes generally are not levied on retained earnings in excess for $250,000
These are some beneficial advantages, but the S Corp is not without its share disadvantages as well.
Some Disadvantages
- Shareholder restrictions (discussed above)
- Shareholders taxed on ALL income of the company even if the income is not actually received
- Profits are reported in a manner that may subject shareholders to a higher tax bracket
- Less ability to take advantage of fringe tax benefits available to C Corps
- Owners must take a reasonable salary, even if the company is not profitable
- S Corporations may be subject to higher IRS scrutiny
There are numerous issues to be concerned with when choosing, forming, and ultimately creating a new entity. Contact Polymath Legal PC at 833-941-6418 today to see how we can assist you on this journey.
For more information, review the IRS’s comments and information on S Corporations.