Deciding what type of entity you want to operate your new business as, is one of the first things you’ll need to do when setting it up. Some of the most common entity options include partnerships, sole proprietorships, limited liabilities and C and S corporations. One corporation in particular has the ability to confuse business owners, and that’s an S corp.
What is an S Corporation?
When applying for S corporation tax status, any shareholders involved must report income classed as ‘pass through,’ on their own tax returns, for their personal income. In doing so, they are able to avoid the issue of double taxation.
What is double taxation?
Occurring when a businesses income is doubly taxed – once at the rate of corporate tax, and again at a personal rate when the shareholders report it on their own, personal tax returns – double taxation can be avoided with the creation of an S corp.
Additionally, an S corp can help protect against personal liability, too.
Double taxation occurs when business income is taxed twice — once at the corporate tax rate, and then again at the personal tax rate when reported by shareholders on their individual tax returns.
What are the criteria businesses must meet for S corporation status?
Before deciding to elect S corp status for your new business, there are 4 specific criteria you must be able to meet and maintain for as long as your business is operating:
- It must be a domestic corporation that operates solely in the U.S.
- It cannot total more than 100 shareholders
- It must only have once stock class
- It must only have shareholders that are allowable i.e. not other partnerships, corporations and non-resident aliens
How could operating your business as an S corp be advantageous?
Now let’s look at some of the advantages typically associated with S corps’:
- Use of Schedule E to report income avoids triggering potential red flags
Because your S corporations’ net income is reported on a single line of Schedule E on your own, personal tax return, you can avoid triggering an IRS red flag regarding any details about income or expense such as might appear on a Schedule C that’s used for income reporting for single member LLCs.
- S corps have a significantly lower audit rate
When completing a tax return for an S corp, expenses related to travel, automobiles and entertainment tend not to attract as much attention from the IRS as they do for businesses completing C corps, as the audit rate for them is significantly lower.
- Big corporations tend to receive more attention from the IRS
With the federal budget not allowing for as many IRS auditors as are needed, their focus tends to center upon bigger corporations with higher spending, than on smaller, S corporations.
- You can avoid a 1099-Misc being issued
By using an S corp status, you can avoid the IRS issuing you with a 1099-Misc as a subcontractor for another business. This gets sent not just to you, but to the internal revenue service, giving them the chance to match up your income.
- Reduce the amount of taxes related to Social Security
Arguably the most significant advantage of operating a business as an S corp, is the money you can save by reducing the amount of Social Security taxes. While LLCs pay this on their net income, S corps are permitted to pay a reasonable salary to their shareholders, with what’s left of the net income taken by the S corp; thereby freeing themselves of Social Security taxes.
Rules for incorporating a business do vary by state, and although the process itself isn’t overly complex or time consuming, it can be helpful to seek guidance from an entity management firm to ensure the process runs smoothly, and that you’re making the right decision for the benefit of your business.