Let’s look at the corporate structure today.
An entity formed as a corporation and operated as such has its own legal and tax life different from its shareholders. There are two types of corporations under the tax code we will discuss today.
The first is the “C-Corporation," or a regular corporation. They exist because state laws allow them to. A corporation will issue stock or shares as evidence of ownership to the person, persons or other business entities that provide cash or assets to the corporation in exchange for a piece of ownership. The shareholders hope that the cash and assets will be used by the corporation to provide a return to them as owners. Shareholders are entitled to any dividends paid and corporate assets after creditors in the case of a liquidation or dissolution.
There are two major reasons for electing to incorporate. The first is limited liability protection. Owners’ liability is limited to the amount of money or assets they have invested in the corporation. In other words, they can’t lose more than what they have put in. This liability shield can be broken for officers or directors of the corporation if there are personal guarantees, tax obligations or violations of statutory duties.
The second major reason is the ability to raise capital. The corporation has the ability to raise capital by selling shares of stock.
There are other benefits such as the business will continue to exist, if well run, well past the death of its shareholders. It has the ability to live forever. A corporation can act on its own and enter into contracts, sue or be sued and can even commit crimes (not recommended.) Employee owners of the corporation are also eligible for better deductions of fringe benefits when compared to other entities.
Disadvantages include the extra formalities of having a board of directors and meeting frequently, having shareholder meetings, and extra costs and burdens or record-keeping.
Another disadvantage is taxation. A corporation will pay tax on its profits. When those profits are distributed as dividends to the shareholders, the shareholders must pay tax on the dividends. This is called double taxation, where the profits if distributed are taxed twice – once at the corporate level and once again at the individual level.
A S-Corporation solves the double taxation disadvantage of the double taxation rules of a regular corporation. A corporation (or even and LLC or partnership) can elect to be taxed as an S-Corporation. This election only changes the tax rules, not the other legal and operation rules of the entity. An S-Corporation will have its profits taxed once at the owners level, similar to an LLC does.
What is the catch? S-Corporations can’t have too many shareholders and generally only individuals can be shareholders. All owners must agree to the election. Only one class of stock can be issued and no nonresident aliens (Think non-US citizens living abroad) can own shares. The election must be made timely, within 60 days of the start of the tax year.
Once elected the S-Corporation gets the same liability protection as a regular corporation, avoids the double taxation, allows the owners to use corporate losses to offset other types of personal income, selling the shares can be taxed at a lower rate and the other big advantage is the self-employment tax savings.
If you are an owner of an S-Corporation (or another entity that has elected to be taxed as one) and you work in the business, you must take a reasonable salary for your work. This reasonable compensation will be subject to income tax and payroll taxes but the rest of the company profits are no longer subject to payroll taxes. This can be a big benefit compared to an LLC or general partnership where all the profits are subject to payroll taxes.
There are other disadvantages such as corporate formalities listed above, less deductibility of fringe benefits for owners, less flexibility and limitations on passive income in the S-Corporation. Many states also have a minimum tax on S-Corporate returns despite them being pass-through entities.
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