Should I Establish An S-Corporation For My Business?

The sub-chapter S corporation was originally created in 1958 to provide the benefits of operating a business inside a corporation, with the liability protection of a corporation but it has many similarities to a partnership.

If a business is incorporated, the corporation will pay the taxes as a C corporation unless you elect to be taxed as an S corporation. The owners of the corporation must file an S corporation election on form 2553. It may be filed anytime during the year prior to election as an S corporation or up to the 15th day of the third month after the beginning of the year. In community property states the spouse of the shareholder must also sign. Basically, this is consent by the owners to have the profits flow through to them as individuals and not be taxed at the corporate level.

Normally S-Corporations must operate on a calendar year.

There are some limitations on who can be an owner of an S-corporation. A C corporation cannot be a shareholder, nor can a nonresident alien. The S-corporation must have 100 or fewer shareholders. There can be only one class of stock. Shareholder debt convertible into stock can be a trap and invalidate the S-election. If one shareholder sells so much as one share of stock to an ineligible shareholder it will terminate the election and the S-Corporation is not allowed to reelect for five years.

The income or losses, of the corporation are taxed to the owners, in the same percentage as they own stock in the corporation. If they own 20% of the business they are taxed on 20% of the profits, 100% ownership taxes 100% of the profits. This is reported on schedule E of their personal income tax return, form 1040.

It should be noted that an owner is not allowed to take a loss from a corporation if that loss exceeds his basis in the S-corporation. Basis is the amount the shareholder has invested in the company, including both stock and loans. It is a very important point to remember that a bank loan to an S corporation even though guaranteed by the owner does not create basis. Should the S corporation have a loss exceeding the investment by the owner, it would not be deductible by the shareholder even if covered by the bank loan the shareholder has guaranteed.

The corporation is required to pay out reasonable salaries. Much litigation has taken place on what is a reasonable salary. Wages and salaries of owners are subject to payroll taxes. Profits beyond salary can be paid out as dividends. There is a tax advantage to this. Dividends are not subject to self-employment tax. This can be a huge savings over a sole proprietor.

The IRS position on dividends seems to hold that profit in an S-Corporation needs to be generated by something other than the efforts of the owner in order for dividends to be paid and not be subject to employment tax. Realtors are a case in point. If all their income is generated by their own efforts, there is little rationale, according to the IRS, for paying out profits as dividends.

There is a fringe benefit problem with an S-Corporation. If getting health insurance and certain other fringe benefits are an issue to the owners, they should be wary of an S-corporation. Health benefits are passed through to an owner as though he received the income and paid for them himself. He is allowed to deduct them on schedule A of his personal return, but oftentimes with income limitations on personal medical deductions that does him little good.

S-elections of existing C Corporation can have tricky tax consequences. That is beyond the scope of this article. Look carefully before you leap.

Liquidation of an S-corporation is less difficult than a C corporation. The basis of the stock is usually roughly equal to the basis inside the corporation, so there is usually no gain on liquidation.

As with all corporations it is wise upon forming a corporation to file articles of incorporation and create bylaws with corporate minutes. Jump through all the legal hoops. A federal corporate identification number is required for payroll, depending on the state, a state number for payroll and corporation tax or sales tax will normally be necessary. Attorneys currently often favor forming an LLC and then filing an S-election. This will work. Some attorneys feel there is a slight advantage in doing so.

There is no magic, if you incorporate your business. Generally with very few exceptions, you are not able to deduct any expenses, which you could not deduct as a sole proprietor, partnership or other form of business organization. The standard for allowing a deduction is that it must be an ordinary and necessary business expense.

One final piece of business advice. The lawyers are quick to make the argument for incorporation as a protection of personal assets from business liability. Each case must be examined separately, because circumstances vary. However more than 30 years of business experience have convinced me the best protection is to carry adequate insurance coverage.

S-Corporations are complicated. The above gives the general rules, but the tax law, and life are riddled with exceptions. Setting up an S-Corporation is not a do it yourself project.