Let’s face it, the only times you will ever think about the structure of your company is when you are starting a new business, bringing on shareholders, or paying taxes. This is not to say that the structure you choose for your company isn’t important, it’s just that more pressing issues will occupy your time as you run your business.
As you might know, there are many different structures that you can choose for your business. These include Sole Proprietorship, Limited Liability Corporation (LLC), and C-Corporation. However, there is another structure you can choose – the S-Corporation.
What exactly is an S-Corp and why should care? Well, here is everything you should know about this type of company and how it could help you.
What is an S-Corp?
An S-Corp is a subchapter of the IRS law which governs how businesses are taxed. This structure is usually used for small businesses – either sole proprietorships or LLCs who wish to use this structure to determine how they will be taxed.
Unlike a C-Corp, where the corporation pays income taxes and then the shareholders pay capital gains on dividends, an S-Corp is a “flow-through” entity. When choosing S-Corp status profits are not taxed at the corporate level but at the level of the individual shareholders. In this way, shareholders can avoid double taxation.
While this is similar to an LLC, there are a few distinctions. First, the IRS treats an LLC as either a sole proprietorship or partnership, depending on the number of members. Remember, there are no shareholders in an LLC.
Second, the members of an LLC can elect to be treated as an S-Corp for tax purposes. This will allow the owners to save money on Social Security and Medicare taxes as well as treat the Owners’ Salary as a business expense. Just keep in mind that an owner will be liable to pay any Social Security and Medicare taxes out of pocket.
Another point to keep in mind is that S-Corps are limited to 100 or fewer shareholders – all of which must be individuals or trusts. However, changes to the tax law now mean that non-residents can now own an S-Corp.
This is an important point as non-residents, including American citizens living overseas, were previously barred from owning these companies. To take advantage of this change non-resident owners will need to set up an Electing Small Business Trust (ESBT) prior to investing in an S-Corp.
What’s Another S-Corp Advantage?
If you are operating a service business, especially a small business, then electing to be treated as an S-Corp will help your business to avoid classification as a “Personal Service Corporation” (PSC).
For example, a consulting company designated as a PSC could expect to be taxed at an initial rate of 35 percent. This is significantly higher than the tax rate for S-Corps and it is just another reason why these structures are often preferred over C-Corps and LLCs.
But…
As with every form of corporate structure, there are cons to setting up an S-Corp. For example, an owner’s shares can be seized by the court and closely held S-Corps might come under scrutiny at tax time.
In addition, the structure might not be the best choice for owners with a high level of personal income as the profits will be taxed as such. Similarly, corporate holdings which appreciate in value (such as real estate) will face higher capital gains taxes than partnerships or LLCs.
Even with these downsides, there are times when an S-Corp makes sense for the company’s owners. The key to choosing the right corporate structure is to talk to your lawyer or accountant and figure what works best for your business.
Also, you want to keep in mind that just because you choose to incorporate in one form today, doesn’t mean that you can’t convert your company to another form in the future. In fact, companies big and small change their status depending on changes in tax laws, the business environment, or even due to growth. One example of this is Blackstone, which recently announced it would convert from a partnership to a corporation.
Why Should You Care?
As mentioned, you probably won’t give much thought to your corporate structure until tax time rolls around. While this is understandable, having the right corporate structure in place can help you minimize your tax liability.
For those operating a small consulting firm or some other service business, you might want to talk to your accountant to about the advantages of an S-Corporation to see if it will not only help you to save money but will also make it easier to run your business.