When taking the first steps to start your business or moving beyond a sole proprietorship, it’s important to learn more about the types of corporations available. In many cases, those looking to grow their business find themselves considering the benefits and drawbacks of an S corporation.
A CPA has the expertise to help you determine what type of business is the right choice for you.
Understanding S Corporations and What They Offer
The type of corporation you form determines, in part, how you are taxed at the federal level. These terms, S and C corporations, are based on the chapter of federal tax law that defines them. Each type has its benefits and drawbacks to the business. We’ll focus on the S Corporations below.
The Advantages of Forming an S Corporation
● Protected assets: Shareholders in an S corporation are not responsible for the liabilities and debts of the business. This means that debts owed by the corporation cannot be pursued by creditors to pay off those debts.
● Pass-through taxation: Unlike a C corporation, S corporations do not pay federal taxes. Any loss or income incurred by the business is passed to its shareholders who report it on their taxes. Losses in the business can mitigate income reported from other sources on those tax returns.
● Favorable Tax-Income Characterization: Business employees can draw salaries as employees, even if they’re shareholders in the S Corporation. They are also eligible to receive dividends from the company, along with any other distributions. These distributions must be tax-free relative to their investment in the company itself.
● Easy Owner Transfer: Transferring ownership of an S corporation does not come with tax consequences. No adjustments need to be made to the property basis, nor are there complicated rules governing accounting to comply with.
● Better Credibility: Businesses established as an S corporation can have a higher credibility profile in the eyes of those they do business with. This is due to the perspective that these businesses are now formally committed to their corporation.
The Bad with The Good: Disadvantages of an S Corporation
● Cost of Formation and Operation: There are several stages to incorporating an S Corporation, some of which involve hiring a registered agent and paying related fees. In some states, you’ll also encounter ongoing fees, including franchise tax and annual reports.
● Obligations and Tax Qualification: Numerous mistakes can be made regarding the requirements for being an S corporation. These include mistakes in filing, notification, election, consent, and stock ownership. Be certain you understand the requirements of your new business model.
● Calendar year: One drawback is that S corporations must have a calendar tax year rather than a fiscal tax year. You can change this if you can establish a solid enough reason your business needs a fiscal year, but it’s not common.
● Restrictions In Stock Ownership: Unlike C Corporations, S Corporations are limited to a single stock class, and only 100 shareholders. These stock shares can be split between voting and non-voting shares, but the business cannot be under foreign ownership. Further, certain entities and trusts cannot own an S Corporation.
● Less Flexible Income and Loss Allocation: It’s not possible for an S Corporation to allocate income or losses to specific shareholders. Instead, this is governed by ownership of the stock.
The above is not a complete list but covers some of the more prominent advantages and disadvantages of forming an S Corporation.
Get Help from The Tax Professionals When Making Your Choice
Your business is growing, and it’s time to make a decision about the direction its growth will take. Don’t try to navigate the complicated world of corporation formation and tax law alone. Reach out to Tax Avenger in Canton and we’ll ensure you understand every step of the process. Together, we’ll determine which direction is right for you and your business and help you on your way. We are a comprehensive accounting and tax firm located in Canton, serving both individuals and businesses with tax preparation and strategy, financial planning and budgeting, accounting services, bookkeeping and more.