S Corporations: Advantages & Disadvantages
There usually comes a time when a business or sole proprietor with a successful business realizes it’s time to take the next step.
This tends to be the process of incorporating your business. This could be by turning it into a C Corporation or turning it into a Limited Liability Company (LLC).
Another option is to register your business as an S Corporation, or an S Corp. But what exactly is an S Corporation? And what are the advantages and disadvantages of having one?
We’ll take a closer look.
Here’s What We’ll Cover:
What Is an S Corporation?
An S Corporation, otherwise known as an S subchapter, is a type of corporation that meets specific requirements. These requirements are set out by the Internal Revenue Code.
Once a business meets these requirements, it can pass income directly to shareholders. An S Corp can do this without having to pay federal corporate taxes.
An S Corp gives a business the regular benefits of incorporation. But it also allows the tax-exempt advantages of a regular partnership.
Shareholders can report business income and expenses on their personal tax returns. These are then taxed at their individual income tax rate. This in turn helps them avoid double taxation on corporate income.
Advantages of an S Corporation
There are many advantages of being a corporation owner for any business type. However, S Corps offer unique advantages that other structures simply don’t. These mostly come in the form of tax advantages and tax breaks.
One of the major advantages of incorporating as an S Corp is the tax benefits when compared to being self-employed.
It can be broken down to for each dollar of profit, you could save around 14% in taxes.
This can only happen once you have paid a reasonable salary to any shareholder or employee. So any remaining profits are no longer subject to self-employment taxes.
This means that S Corps can avoid double taxation on their income.
Health Insurance Taxes
Having your S Corp pay for your family health insurance coverage means that you can save additional payroll tax.
For this to work, it would have to be included as a part of their wages.
Having an S Corp with shareholder-employees means that out-of-pocket business expenses can be paid by a worker. These are then reimbursed by the Corporation.
Being able to do this would require you to have an Accountable Plan.
An S Corporation can provide retirement contributions to its employees of up to 25% of their compensation. However, this is capped at $56,000.
An S Corp without any other employees can set up a Solo 401(k) plan. This would allow them to defer up to $19,000 of income from taxes, though you will still need to pay them eventually.
Disadvantages of an S Corporation
Whilst there are some unique advantages to having an S Corp, these can be weighed up against some disadvantages.
Any assets that your company owns that have appreciated, cannot be distributed to you or your co-owners without generating a tax bill.
Single Stock Class
Raising cash through a stock offering can be difficult with an S Corp. This is because an S Corp can only issue one class of stock.
There are a lot of rules and regulations when it comes to taking money or assets out of an S Corp.
For example, for anything to be withdrawn it must first be characterized as compensation, a dividend, a loan or any other form of payment. This is for tax purposes.
For a business to be registered as an S Corp, it must be domestically based. Any shareholders must also be U.S citizens.
This means that you wouldn’t be able to rely on any foreign investments which, depending on your business model, could prove problematic.
S Corporations provide a good option for small business owners.
This is because they can avoid being hit by some significant taxes compared to if they were a regular corporation.
When you are considering which legal structure to move forward with, you should always consider your options. It's important that you choose what is best for your business structure.
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