If you are a small business owner, you are likely to own your business through a business entity such as a corporation or limited liability company (LLC). You might also choose to have your business entity taxed as an S corporation.
First, what is an S corporation? This refers not to a type of corporation or business, but rather to a type of income taxation. This generally creates lower tax rates for the business owner, and avoids tax consequences such as self-employment taxes or corporation-level taxes.
In order to be eligible for S corporation status, a business must be owned by natural persons — in other words, by people rather than by other business entities.
Here’s a brief introduction:
Hi. This is Barry Haimo. Thanks for tuning in for another dose of Bite-Sized Bits of Knowledge, where we give you meaningful information in a short amount of time. We just finished up the corporations video and today we’re going to talk about S-corporations.
So S-corporations are legally a corporation at the state level. The state doesn’t care what you are. You’re a corporation. You’re an ink. You’re a corp. You’re a corporation designation at the end of your company name.
S-Corps, however, have an election to be treated differently from a C-Corp and to be treated as an S-corporation. It’s an affirmative election. You have to make it with the IRS. The IRS is the only entity that cares about whether you’re a corporation or not, okay? And that’s done on a special form and it needs to be done on time.
S-corporations are important because they put restrictions on corporations that don’t otherwise exist. To keep that tax designation, some of the restrictions are as follows. First, you’re limited in number and type of shareholders. Specifically, you’re limited to 100 shareholders and all those shareholders must be US citizens and they look through the shareholders to see who the shareholders are in terms of what’s called related parties to make sure that you’re not saying there’s 100 shareholders but there’s really 1000. Okay?
You’re also limited in the types of classes of stock that you can have, whereas a C-Corp can have multiple classes with preferred and common and class one, class two, class three. And an S corporation, you’re limited to non-voting and voting of one class of stock. So you’re very limited there in terms of taxation.
It’s very different in a corporation. You have your 1120s and it’s taxed at the entity level and then dividends or distributions are taxed again at the shareholder level, thus making it double taxation. In an S-corporation, the S-corporation files an 1120s with the IRS that just reflects the profits and losses and the shareholders and their percentage interest in those profits and losses. And then the shareholders report their share on their 1040s.
So they get a K1, they give their K1 to their account – their CPA – and the CPA prepares their returns including those profits and losses on their personal returns. So you could theoretically have five partners where one is a doctor, one’s a teacher and they all make different incomes and they’re all going to pay different amounts of tax on the same amount of percent of interest because each one is paying their own tax based on their own personal income.
So it could be a lot lower taxes as a result than the C-corp. I would say the only limitation on transfers of interest that a C-corp doesn’t have would be you just got to be mindful that if you violate your S-corporation restrictions, you’re going to lose your status as an S-corp. And that’s bad because that could be a taxable event. That can cause you to basically have to pay a lot of taxes. So you really want to be careful about that.
I would wrap up by saying that S-corps are great for small businesses that are service businesses and they want to stay small. If you’re looking to get bigger, scale, grow, go public, you cannot be an S-corp. I’d highly recommend that. And also make sure your CPA doesn’t kneejerk you into an S Corp prematurely without getting your holistic counsel like we’ve told you.
So I hope you found this helpful. Don’t forget to download our free Florida business entity chart and our free business planning stress test. The links are in the description. Thanks again for stopping by, and stay tuned for more.
Now that you understand S corps a bit better, let’s do a quick compare and contrast with a few other business structures.
Should You Consider a C Corporation Instead?
While it’s great that you decided to incorporate your business, there are a few different types of corporate structures from which to choose.
Below, please find some pros and cons of C corporations versus S corporations. What’s important to remember is that both entities are essentially the same for state law purposes – the S corporation is distinct for tax purposes only.
Choosing to Incorporate Your Business
C corporations and S corporations are very similar, with both sharing the following characteristics:
- Limited liability
- Credibility with investors – raising capital is typically easier
- Transferring ownership is typically easy
- The corporation can exist past death of owners
- Easier to establish benefits, including retirement plans
Forming a C Corporation
When you complete the Articles of Incorporation to make your business official, the entity will become, by default, a C corporation. Additionally, an S corporation can always become a C corporation if you change your mind or decide to expand – though if you have intentions of growing quickly and having shareholders outside of the United States, you will have to file as a C corporation from the get-go.
The downside? C corporations are taxed twice. Net income is taxed at the corporate level and must be paid by the corporation as a whole. Then individual shareholders have to pay taxes on distributions on their dividends. While dividends enjoy a reduced tax rate, the amount received is nevertheless taxed twice.
Forming an S Corporation
Forming an S corporation requires a specific request. Why would you want to file to have an S corporation? The difference all boils down to one word: taxes.
S corporations have a similar tax structure to a partnership or an LLC. Income passes through the entity and is taxed only one time and at the shareholder level. There may be additional taxes for S corporations that switch to S-status later on, so if you wish to have S-status, do so within the first 90 days of filing as a corporation.
S corporations can only have 100 shareholders or less, and all must have citizen or resident alien status. There are also certain complications that come with transferring the ownership of an S corporation. Owners have to include their shares and expenses on their personal returns.
Which Is Better?
There is no “better” or “worse” type of corporation. The structure that is best for your business will depend on the size of your business, your partners, your goals, and the tax structure that you prefer.
If you are filing to be a corporation because you are uncomfortable with the LLC form, you may want to stick to electing s-corporation -status. If you plan to see more growth, or don’t want to go back and forth and file additional paperwork to change the structure of your business, it may save you a headache to skip the s-status and file as a c-corporation.
What about Forming an LLC?
Business entities are designed in large part to limit the exposure to liability that owners/investors/shareholders may face. They all do a good job of protecting the owners from creditors of the business, or “inside creditors”. However, they are very different with respect to how they protect owners’ interests in the entities from their personal creditors, or “outside creditors.”
Why? Because you are significantly less protected from your personal creditors with a corporation electing to be treated as a small business corporation (S corp).
In other words, you are exposing yourself to unnecessary liability and you are at risk of having your business being taken away from you. The reason primarily has to do with reducing self-employment taxes, which was probably the main factor contemplated in the decision to elect to be treated as a S corporation.
Estate Planning for S Corporations
Although an S corporation must generally be owned by individuals, there are some exceptions to that rule. One of which is living trusts.
Living trusts are ignored by the IRS for income-tax purposes, meaning that an individual can hold their S corporation stock in a living trust. However, after the guarantor’s death, beneficiaries can generally only hold their stock in the living trust for two years.
However, beneficiaries can hold S corporation stock in a living trust for longer than two years so long as the living trust meets certain criteria:
- The trust is an electing small business trust (ESBT), in which all beneficiaries are individuals or estates
- The trust is a qualified subchapter S trust (QSST), which has only one income beneficiary that can receive trust principal distributions throughout their life
Beneficiaries can also transfer S corporation stock to certain other entities — for example, charitable organizations — and avoid tax consequences.
Loss of S Corporation Status
Should shares of an S corporation be transferred to the wrong type of trust or other business entity, this can result in loss of S corporation status.
This has significant tax consequences for both your estate’s beneficiaries and the other shareholders of the business:
The S corporation status is lost, meaning that a double tax regime will apply. This means that income generated by the corporation itself will be taxed at a rate of 15-23.8%, and any income transferred to the shareholder will be taxed a further 21%. This applies to all shareholders.
Remaining shareholders still operating the business will be further subjected to self-employment taxes.
Even if your share of the business is transferred back to a qualified stakeholder, the business cannot seek S corporation status for five years.
Clearly, the criteria for maintaining S corporation status are complex, and any breach of these criteria due to poor estate planning can be costly not only to your beneficiaries, but also to other shareholders. It’s important to make sure your business tax choices are in line with your estate planning goals.
Want to learn more about S corps and other business structures before deciding which one is right for you? We can help. Reach out to our office today to speak with an experienced Florida business planning attorney.