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S corporation is a term that comes up whenever a business owner seeks advice regarding how to structure the business. Many people have strong views on which is better—an S corporation or an LLC. The fact is that there is not a single perfect choice. The best choice depends on the type of business, the plans for the business and the short- and long-term goals of the owners. This article will help you understand the advantages and disadvantages of an S corporation, which is an important first step in determining if the S corp is the right option for your company.
CT Tip: While there are many similarities across all the states, each state is slightly different. It is important to consult with a business professional that knows the ins and outs of each state’s laws.
While conventional wisdom views the following as advantages that an S corp offers its owners, it is important to realize that what is generally an advantage could be a disadvantage in some cases. For example, pass-through taxation generally is positive, but if you want to accumulate money for expansion—perhaps to build a new facility—a regular corporation could be the better choice because income can be retained within the corporation.
Asset Protection. One of the major advantages of the S corporation is one that is shared by regular C corporations and LLCs. Operating as an S corporation, an LLC or a C corporation offers the owners limited liability protection. This means that the owners’ personal assets are shielded from the claims of business creditors—whether the claims arise from contracts or litigation.
Pass-through Taxation. An S corp is a pass-through entity for federal (and most state) income tax purposes. (It shares this advantage with the LLC.) Business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level. This avoids any chance of “double taxation,” which comes into play when dividend income is taxed at both the corporate level and at the shareholder level.
Salary and Dividend Payments. An S corporation owner can opt to receive both a salary and dividend payments from the corporation. This can result in an overall lower tax bill. Why? Because dividends are not subject to self-employment tax. Further, the corporation can deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders. However, the division between salary and dividends must be “reasonable” as determined by the IRS. (The IRS watches these types of transactions very closely and will step in and re-characterize the income if it feels the payments were unreasonable.
Ease of Conversion. An S corporation can be converted to a C corporation more easily than an LLC can. As S corporation status is simply a matter of a federal tax election, no secretary of state paperwork is required if the election is terminated. In contrast, an LLC must formally convert to a corporation by filing the appropriate documents with the secretary of state in the formation state and every state where it has qualified to do business.
As noted earlier, some advantages can function as disadvantages for certain businesses and business plans. Here are some of the “dark side” of the advantages, as well as some that are inherent in operating as a corporation, rather than the more flexible LLC.
Strict Qualification Requirements. In order to be eligible to make an S corporation election—and to continue to be an S corporation—the corporation must meet strict requirements on number and type of shareholders and types of shares. Briefly stated, these rules include:
Rigid Profit and Loss Allocation. Because it is a corporation, an S corporation is required to allocate profits and losses among the owners based strictly on the percentage of ownership or number of shares held. In contrast, an LLC is able to allocation its profits and losses in whatever proportions the owners desire. Thus, the founding owner who transfers 50 percent of the ownership to a new member could receive a disproportionate share of the income from the LLC. In an S corporation, the founders allocation is reduced from 100 percent to 50 percent.
Corporate Formalities. At the risk of being redundant, it must again be stated that an S corporation is first and foremost a corporation. That means that it must observe all the corporate formalities imposed by its home state and the states where it is registered to do business. (In contrast, an LLC faces far fewer formalities)
S corporations can be the best choice if you are looking for a company structure that provides pass-through taxation and permits both salary and dividend payments. However, there are requirements that must be met in order to make the election and must continue to be met for the election to remain valid. The advantages of allocating income between salary and dividends must be balanced against the lack of flexibility and the more extensive formalities imposed on a corporation versus an LLC.
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