When starting a new business or if your business is growing, small business owners may want to determine which type of business structure they should use. There are many different options and they can be confusing. When a person or persons choose to start a business they should consult an accountant or an attorney on what is the best option for them. Even if you choose to start your business as one structure, you can always change. It is a simple process.
An S-Corporation is one type of organization that is becoming popular. It offers many advantages but also contains some disadvantages. I will explain these in this blog.
An S-Corp is a corporation and has the advantages and also the requirements of a corporation. In order to maintain your status as a S-Corp you must meet all the rules of a corporation including the holding of a board meeting at least once per year and the issuance of stock. When completing the paperwork to elect S-corp status you state who the shareholders are and how much stock they each own.
An S-corp is a pass through entity. The earnings are passed through to the owners even if they are not distributed. This may cause a cash flow problem if not considered beforehand. However, an advantage of this is that the earnings may be passed through to the owners via wages or dividends and thus reduce the earnings of the corporation. Another advantage is the reduction or elimination of the self-employment tax. A sole proprietor, partnership or LLC suffer the cost of self-employment taxation. This can be a significant cost if the business earnings are large. A general rule of thumb is, if the net income is above $15,000 the owners should consider other options to reduce the self-employment tax. Incorporating as an S-Corp will solve this problem.
Those who are contemplating choosing to incorporate as a S-Corp should realize that all owners need to be U.S. Citizens and that there cannot be more than 100 of them. Also Corporations cannot be shareholders of the S-corp. There can only be one class of stock. This may be a disadvantage but may also be an advantage. It serves to keep the company simpler.
Another disadvantage is that capital gains on assets will incur higher taxation rates than with C-Corps or LLC’s. Also if the company is sold within 10 years of being incorporated the gain on the sale of the company is taxed at a higher rate. If you are contemplating S-Corp, then do it sooner to start the 10 year window.
Another disadvantage is that owners/shareholders with more than 2% stock cannot receive tax free benefits. This may be a problem with smaller companies such as a Mom-Pop business.
Generally though, S-Corporations may be a good fit if you are looking for a company structure that offers pass-through taxation and allows both salary and dividend payouts. These advantages must be balanced against the lack of flexibility and the extensive formalities that need to be followed.