LLC formation S-Corporation formation asset protection

Why form an S-Corporation?


By: S W Haeger

What is an S-Corporation and why should I use it?

You should always ask this question when starting up a new business or incorporating your partnership or sole proprietorship, as S-Corporations do have their benefits and are certainly worthy of consideration. Typically in the United States you will be choosing between an S-Corporation, C-Corporation, and Limited Liability Company.

A primary consideration in business formation and incorporation is how they wish to be taxed in the future. An S-Corporation can make a huge difference in the amount of tax liability faced by a company, but the extent of that effect will depend largely upon a number of factors.

Like an LLC, an S-Corporation is a company that opts to have it’s profits flow through directly to the owners of the corporation as a “flow-through” entity. In this way it can be treated identically to a limited liability company. For point of reference, the “S” in S-Corporation refers to an IRS code section that must be elected in order to proceed as such a company. It is the S eletion that allows the shareholders of the company to be taxed only at the individual level rather than the double-taxation that a C-Corporation faces at both the corporate and individual level, this because there is no federal income tax requirement at the corporate level of an S-Corporation. S-Corporations become an attractive choice for smaller corporations seeking single taxation while maintaining some of the corporate formalities of a C-Corporation that make it more attractive to potential investors.

It is important to keep in mind that, unlike the LLC, the S-Corporation has significant limitations on ownership, especially for individuals whom are not citizens of the United States. There can only be 100 or fewer owners, and all of those owners must either be individuals or living trusts. Multi-member LLC’s, corporations and non-US residents cannot be S-Corporation owners under any circumstances. If these restrictions are not carefully followed and maintained, and the IRS finds out (and trust me, they always do) then the company will face the real possibility of being taxed as a C-Corporation and the double-taxation that comes along with it.

But is an S-Corporation right for me? What should I choose?

You should immediately consider forming an entity of some type if your business currently operates as a sole proprietorship or general partnership. Neither of those business types offer the owner any type of asset or personal liability protection, such that one false move or mistake could lead to the ruin of both the business and that person’s professional career. An individual faces the possibility of losing all of their personal assets should they get sued because of something that occurred in the day to day operations of the business.

Understanding that, why should I choose the S-Corporation over some of the other entity types?

S-Corporations are highly recommended by under two distinct scenarios. The first is either the startup or the expanding general partnership, sole proprietorship or LLC that is seeking investors of any type. Investors, especially venture capital outfits, often don’t see LLC’s as permeant enough to be worth their investment and don’t see general partnerships or sole proprietorships as companies that have expended the time and effort commensurate to become a truly successful business.

The other scenario is one where you are incorporated as a C-Corporation and face the possibility of being labeled a personal service corporation by the IRS. This can occur where the only services a company provides are personal services, and specifically has become a target of the IRS when auditing “consulting” companies, which tend to be one man outfits and often are guilty of under-reporting income. If starting a consulting company it is highly recommended you start an S-Corporation as opposed to an LLC or C-Corporation, so, if this is the case in your situation, please contact us as soon as possibility so we can get started for you right away.

What are the other advantages of S-Corporations?

  1. There are no state residency requirements on the managers of the company, and they can be unlimited in number.
  2. Personal liability protection so that owners are not in danger of losing their home, personal property, or savings.
  3. In certain states the privacy protection afforded by an S-Corporation is significant. This is especially true in Wyoming and, to a certain extent, Nevada.
  4. Provides better income splitting potential with employees than LLC will allow, as owners can take a smaller salary, paying income and payroll taxes, the take the remainder of profits as a distribution of income subject only to income tax (thus being treated more closely to a C-Corporation).
  5. Startup costs will not be significant, though will likely be more than if forming an LLC.
  6. S-Corporations are ideal for new or transitioning companies that intend on being service based companies, will not have significant startup costs in the way of equipment or other capital expenditures, and will make a sizable amount of money without much in the way of expenses.

So there have to be some disadvantages to the S-Corporation, what are they?

  1. Maximum of 100 shareholders, all of whom must either be United States residents or resident aliens. All ownership of shares must generally be in the form of direct ownership.
  2. If a shareholder owns more than 2% of the shares of the company the company’s shares cannot receive any tax-free benefits.
  3. In the case of high income shareholders, flow-through taxation presents the very real possibility of being taxed at a higher individual income tax rate than the personal income tax rate.
  4. Startup costs can typically exceed those of some other corporation types.
  5. More paperwork and more maintenance requirements than those of an LLC.
  6. Only one stock class designation may be used.
  7. Not particularly useful for investment companies, as the capital gains tax rate on the sale of assets will typically be higher than other corporate form types, primarily the LLC.

I will be the sole shareholder. Will I be subject to the self-employment tax?

Not if you make the S corporate election, no. Owners will be taxed on the salary they pay themselves. Each owner that also works as an employee of the S-Corporation must be paid a salary that is reasonable and customary based upon the job they perform, and this salary must be subjected to all the usual payroll taxes, such as social security and Medicare. Thus, the savings from the self-employment tax is only realized by the owners after the salary and payroll taxes are all deducted and paid out for the fiscal year by the S-Corp. In other words, this benefit is only realized on dividends.

Contact us via the contact form below today and we will work together to decide whether the S-Corporation or some other corporate form is right for you. Be sure and tell us a little bit about your business and what you are seeking to accomplish with incorporation and we will get back to you within one business day (either by phone or email) to discuss your options. In the alternative, if you are already sure of what you want, head over to the store and make your purchase today!

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