What is an S Corporation and How Does it Work?
Updated: Aug 14
When you run a business of your own, taxes never stray too far out of mind. When to pay them, where to file, and how to receive tax breaks are all frequent topics of conversation.
Before 1958, entrepreneurs had two options for how to form a business entity: a Partnership or C Corporation. However, neither of these structures met the needs of business owners, which lead Congress and President Eisenhower to create the Subchapter S Corporation.
Here’s a quick run-through on the basics of S Corps and how this designation could help your business.
What is An S Corp?
A Subchapter S Corporation, commonly referred to as an S Corporation or S Corp, is an IRS tax election option available to eligible businesses. The name comes from the section in which it appears within the Federal Internal Revenue Code.
Having an S Corp designation allows businesses formed as Limited Liability Companies (LLC) or C Corporations (C-Corp) to receive special tax treatments. If you're considering this transition, King's Dream Business Consulting can guide you through the process, ensuring you understand all the benefits and potential challenges.
The Advantages of an S Corp
Here are only some of the benefits of becoming an S Corp:
May decrease the self-employment tax burden on members of an LLC: Most times, LLCs are considered pass-through tax entities. This means that all of an LLC’s profits pass through to its owners’ personal tax returns. The members pay income tax and self-employment taxes (like Social Security and Medicare) on all of the business’s profits. However, as an S Corp, only wages and salaries paid to LLC members through payroll are subject to self-employment taxes. The rest of the profits are paid as distributions to LLC members and fully avoid Social Security and Medicare taxes.
Can help avoid double taxation: With a C-Corp designation, a company’s profits and losses immediately flow through to its shareholders’ personal tax returns. These profits are not taxed at the corporate rate. Shareholders who are employees of the corporation pay self-employment taxes only on the wages or salaries they receive from the business. They do not pay Social Security and Medicare taxes on income paid to them as dividends.
Business owners receive personal liability protection: Creditors usually choose not to pursue the owners of an S Corp’s personal assets (house, bank accounts, etc.) to pay business debts or settle legal disputes.
The Disadvantages of Becoming an S Corp
In addition to the positives, we see negatives to becoming an S Corp as well. These include:
May stunt business growth: S Corps may not have more than 100 shareholders. Compare this to LLCs and C Corporations, which can have unlimited shareholders.
Could come under closer scrutiny by the IRS and other tax authorities: S Corps need to make sure the wages and salaries to owners are reasonable for the type of work and industry. If an owner’s wages are too low, it may make the IRS suspicious. This may cause the IRS to recharacterize wages and distributions—which will affect tax outcomes.
Stricter ownership requirements: Only eligible domestic corporations and LLCs can obtain S Corp status. The IRS also restricts who may be shareholders of an S Corp, making partnerships, corporations, and non-resident aliens all ineligible. LLCs and C Corporations, however, have fewer restrictions on who may own them.
How to Form an S Corporation
Reading this might have you ready to file your S Corp paperwork, but first you need to ask yourself “Should I become an S Corp?”
Before making any big moves, entrepreneurs should seek professional tax and legal guidance to determine whether or not becoming an S Corp would be in their best interest. Although the application process only takes a few weeks to process, business owners may need help filling out the necessary paperwork. Additionally, there are certain deadlines that must be met to receive status within the year, and outside assistance may help keep you accountable.
Becoming an S Corp could revolutionize your business. For more information on how to elect S Corp status—and whether or not it's in your best interest to do so—contact King's Dream today.
About King's Dream Business Consulting: Founded in 2019, King's Dream Business Consulting is a small business consulting and management firm established initially in response to Seattle's gentrification and displacement of its minority business communities. To Date, King's Dream has served over 200 small businesses nationwide. King's Dream Business Consulting is a leading provider of business advisory services, offering strategic planning, marketing strategies, financial management, operational efficiency, and human resources consulting. Committed to the success of small businesses, King's Dream Business Consulting provides tailored guidance and support to drive sustainable growth.
Samaria Johnson writes many things, hopefully none of which you consider boring. She loves taking complex information and breaking it down into engaging, understandable content. Samaria’s goal is to only use her words in ways that help make the world a better place.
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