One of the most common questions I get asked is what whether a small business should become an S Corporation. Choosing the right type of structure and tax designation for your small business is a vital step that should take place early on because it’s important to help your business thrive.
What IS an S Corporation?
An s corporation is actually NOT a type of business formation. In order to be an s corporation you must first form your business as a limited liability company for legal purposes. From there, if you meet certain requirements, you can elect to designate your business as an s corporation for tax purposes.
In order to meet the IRS requirements to designate as an s corporation your corporation must, have fewer than 100 shareholders who are all individuals, not corporations; have only one class of stock available; and be owned by U.S. citizens or resident aliens.
What is the Advantage of Choosing S Corporation Tax Status?
The major advantage of becoming an s corporation for most people? Substantial tax savings. Different to c corporations (the most common type of corporation structure chosen), s corporations are not subject to double taxation. The s corporation status allows for a business’s income, losses, and deductions to be passed onto owners or shareholders when they file their income tax. That means that an s corporation’s revenue is not taxed at the corporate level. It's only taxed when paid out as salaries or dividends to shareholders, so the company is not required to pay federal income tax because the profit has technically been passed on to the individuals. That’s a huge benefit for small business owners.
Things you should consider before designating as an s corporation include how the IRS classifies businesses. The IRS defines businesses as sole proprietorships, partnerships, C corporations or S corporations. The IRS has no limited liability corporation (or LLC) tax designation, which means that a single-member LLC is taxed as a sole proprietorship while a multi member LLC is considered a partnership. However, LLC owners can choose to be taxed as an S-corp if the file the appropriate documents with the IRS.
The Big Difference between LLC taxation and S corporation taxation
If you choose by default to have your LLC taxed as a sole proprietorship, this means that as a business owner you are required to report business income and expenses on your personal income tax return, pay personal income tax on company profits and pay Social Security and Medicare taxes on said profits.
If you choose instead to have your LLC taxed as an S corporation, your "reasonable salary" will be a business expense so you will report salary and other business profits on your personal income tax return. But, the big thing is you will ONLY pay self-employment taxes (Social Security and Medicare) on your "reasonable salary". The business profits will not be taxed for self-employment purposes (but will still be taxed for all other purposes), so you could save a substantial amount of money each year in tax liability.
Is forming an S corporation right for you?
The important thing to think about when deciding whether or not to designate s corporation status is if the tax benefits are right for you. This may require the help of a professional so I highly suggest you contact a CPA or other tax professional in order to help you determine if this is the best designation for your business. Every business is different, and determining the "reasonable salary" for you as the business owner can be tricky, so its best to work with a certified CPA on this!