When you start a new business, you are confronted with a choice – what type of business entity to employ? The most common business entities among small businesses are sole proprietorships, limited liability companies, and S-corporations. Which one is right for you? This post will summarize the pros and cons of S-corporations. Look here to learn about sole proprietorships. Look here for a summary of limited liability companies.
An S-corporation has certain tax advantages relative to an LLC or sole proprietorship. The business profits in excess of the owner-employee’s salary or wage are subject to federal and state income tax, but are not subject to self-employment or payroll taxes. That can result in a tax savings of between 2.9 – 15.3% on those profits.
Similar to an LLC and unlike a sole proprietorship, an S-corporation offers a layer of liability protection to the business owner. In general, the personal assets of an S-corporation owner are shielded from creditor claims arising from the business – adding a layer of protection for your bank accounts, automobiles, and real estate, among other things. Keep in mind, a court may still override that layer of protection, so it’s still good to have insurance and some risk tolerance.
The setup for an S-corporation is a little more involved than an LLC and a lot more intrusive than for a sole proprietorship. A certificate of incorporation or similar document (depending on the state) is required to be filed with the Secretary of State (in Idaho, the filing fee is just $100). The S-corporation must obtain its own tax identification number – an EIN, and it must file an election with the IRS to be treated as an S-corporation.
The tax law also allows for companies organized as limited liability companies under state law to elect to be treated as S-corporations for federal and state income tax purposes.
S-corporations are required to file a tax return separate from their owners – form 1120S. The S-corporation does not generally pay income tax on its return, though it sometimes may elect to pay state income tax on behalf of its non-resident members. Additionally, some states have a minimum annual fee or tax ($20 in Idaho). Instead of paying the income tax at the corporate level, the income (and loss) from the S-corporation flows through to the individual returns of the members on a form K-1.
An S-corporation has certain disadvantages relative to an LLC or sole proprietorship. Those disadvantages come generally in the form of increased administrative burden. An owner-employee is required to pay himself/herself a reasonable salary or wage for services provided to the company. That salary or wage is subject to payroll tax withholding and reporting – which can include monthly, quarterly, and annual tax payments and tax filings. Additionally, S-corporations may have more stringent state requirements to maintain their liability protection – such as regular periodic board meetings and minutes.
One big draw back for multi-owner S-corporations is flexibility. While a multi-member LLC can allocate income, losses, or distributions in most any way that makes economic sense, an S-corporation must allocate its business activity and distributions only according to the ownership percentages. That can make divergent interests difficult to satisfy.
One last set of disadvantages for an S-corporation over its peers is the potential for taxable gain when appreciated assets are distributed to its owners or when distributions are made from the company in excess of basis (usually because of debt financing in the company). While these taxable gain issues may affect a relatively small percentage of S-corporations, they can have unexpected and expensive effects.
It’s legal disclaimer time: This post is informational in nature, and does not constitute legal or tax advice. We would, however, be happy to consult with you to determine which of the ideas presented here, if any, should be implemented in your specific situation.