Many business owners assume that incorporating their business will be too costly or time-consuming, but this is not always the case. If you are just starting your business or have been operating as a sole proprietorship or general partnership, you may be wondering about the advantages of incorporating your business as an S Corporation.
In this article, we explore the tax-deduction advantages and disadvantages of the S Corporation.
What Is an S Corporation?
To form an S Corporation, you first create a standard LLC or corporation. You then file paperwork with the IRS to be taxed as an S Corporation rather than a normal business entity.1 Therefore, your legal organization is still an LLC or Corporation, but for tax purposes, you are now classified as an S Corporation.
Federal taxes treat your S Corporation as a pass-through entity, which means the company’s income and expenses get reported on Schedule K-1 for each shareholder. For some business owners, this is beneficial because it offers personal tax liability protection.
If you can handle the tax-law limitations, an S Corporation has several advantages, regardless of whether your business has one or many owners.
3 Advantages of an S Corporation
The advantages of an S Corporation outweigh perceived disadvantages. The S Corporation structure can be beneficial when it comes time to transfer ownership or discontinue the business. These advantages are typically unavailable to sole proprietorships and general partnerships.
Let’s look at three advantages of incorporating as an S Corporation:
Liability protection.
In short, if you operate your business as an S Corporation, your personal assets will be safe from any debts or liabilities related to the company under state law. These can include things like a lawsuit from the FedEx guy who slips on some ice at work, to more continuous problems like employee misconduct.
Key Point: An S Corporation will not protect your personal assets from exposure to professional malpractice or tortious act liabilities. Tortious acts are wrongful deeds committed other than through a breach of contracts, such as the negligent operation of a motor vehicle resulting in property damage or injuries. The issue of liability exposure is governed by state law so it is important to consult with a trusted business attorney for more information.
Pass-through taxation.
With an S Corporation, your share of the business’s taxable income items, deductions, and credits are passed through to your personal return. You pay taxes at the personal level on your share of the corporation’s profits; in most cases, there is no corporate-level tax. Thus, you don’t have to worry about double taxation potentially occurring as it sometimes does with C Corporations2.
Tax-favorable characterization of income.
S Corporation shareholders can be employees of the business and receive a salary as an employee. They can also receive dividends or other distributions from the corporation that are tax-free up to their investment in the corporation. Being reasonable with how you characterize distributions as either salary or dividends can help reduce self-employment tax liability while still generating business expenses and wages paid deductions for the corporation.
3 Disadvantages of an S Corporation
An S Corporation may have some potential disadvantages, including:
Extra Tax Return Preparation and Legal Fees
Unlike Form 1040 Schedule C of a proprietorship, the S Corporation tax return includes a balance sheet in addition to the required K-1 pass-through information. To ensure that you get the right numbers in the right spots on your S Corporation tax return, you should use a professional tax preparer.
Your S Corporation is a corporation, and that means you also need corporate paperwork. To get this right for both tax purposes and legal protection, you’ll need to use an accountant and an attorney .
Thus, the first disadvantage of choosing an S Corporation rather than a proprietorship is the extra cost of tax returns and corporate compliance.
Possible Extra State Income, Franchise, or Similar Taxes
Depending on your location, your state may require that your S Corporation file and pay a state income, franchise, or similar tax. You might think this is unbalanced because the state’s levying of an extra tax on the S Corporation doesn’t result in a compensating deduction for you personally.
Trapped Assets
The S Corporation’s assets are not your personal assets. They are business assets. If you try to take them from the company, in most cases it will result in a negative tax consequence for both you and/or the corporation. However, with a single-member LLC or proprietorship, you have more leeway to take assets without triggering a taxable event.
One area of concern for all businesses is recapture. If you are thinking of converting an asset to personal use or making a lot more personal use of an asset, make sure you know the recapture rules.
How to Move Forward
To form an S Corporation, you must first form a corporation by preparing and filing Articles of Incorporation or a Certificate of Incorporation with the proper state authorities. You must also pay filing fees and any applicable initial franchise taxes or other fees. The type and amount of information required in the incorporation documents may vary from state to state. For help navigating the complexities of starting an S Corporation, reach out to SYM today and one of our business professionals will help you navigate the waters of incorporation.
1 IRC Section 1361(a)(1); The LLC can elect to be taxed as (1) a C corporation, by filing IRS Form 8832 with the Internal Revenue Service, or (2) an S corporation, by filing IRS Form 2553.
2 The partnership tax provisions are found in IRC Sections 701-777.
Disclosure: The opinions expressed herein are those of SYM Financial Corporation (“SYM”) and are subject to change without notice. This material is not financial advice or an offer to sell any product. SYM reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. SYM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about SYM including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.
