Incorporation provides key benefits for small businesses. The owners are shielded from personal legal liability and tax benefits increase profitability. But what type of corporation serves small business owners best?
S Corps provide the most substantial benefits for the majority of small businesses.
Taxes are cut drastically versus a C Corp, tax filings are annual, and up to 100 shareholders can participate in the ownership. Because an S Corp saves businesses so much money, it may be the most sensible option for your company.
C-Corps: The Double Taxation Trap
How would you like to pay your income taxes twice? Chances are, 100% of readers just answered no!
If you elect to run your business as a C Corp, you pay taxes twice: Once when the company books the profit and again when shareholders receive their cut.
This double taxation exists because of a quirk in the tax code that allows the IRS to dip into the same money once on the company’s tax return and again on shareholders’ personal tax returns.
You work hard enough to generate profits amid rising inflation, labor shortages, and supply-chain disruptions. The last thing you need is the IRS making it doubly difficult. To protect your hard-earned money, organize your business as an S Corp and eliminate the C Corp double taxation trap.
How S Corps Avoid the Double Taxation Trap
S Corps allow you to gain the protections of incorporation without suffering from the C Corp double tax problem. S corps work as pass-through entities. Instead of the IRS taxing the business and the shareholders, the earnings “pass-through” the business without taxation. The IRS collects only from the shareholders when they receive distributions.
Business losses also “pass-through” the corporation to the shareholders. As a result, they can deduct business losses on their personal tax returns, another advantage.
The IRS limits deductions to the amount of capital the taxpayer invested in the pass-through entity.
Advantages of an S Corp
The advantages of S Corps extend beyond the avoidance of the double taxation trap:
• Limited Liability
S Corps enjoy the limited liability privileges of C Corps and LLCs. So long as their activities remain within the bounds of the law, company directors, officers, shareholders, and employees have strictly limited personal liability for debts incurred by the organization.
• Pass-Through Taxation
Owners report their share of the profit and loss on their personal tax returns. This income can be taken as dividends, salary, or other compensation mechanisms.
• No Double Tax
As illustrated above, no IRS double-dipping.
• Investment Opportunities
As an S Corp, your company can recruit new investors through stock sales.
• Perpetual Existence
S Corps remain legal entities after the departure or death of the owner.
• Annual Tax Filing
C Corps must file quarterly, while S Corps enjoy annual filing requirements.
S Corp Disadvantages
Despite the benefits of S Corps, there are some disadvantages to contemplate:
• Eligibility
Is Limited to U.S. Citizens and Permanent Residents. Non-citizens can create LLCs but not S Corps.
• Limited Shareholder Participation
The government limits S Corps to 100 shareholders or less.
• Complex Formation Process
To form an S Corp, you must file articles of incorporation in your chosen state, create a C Corp, and then convert it to an S Corp.
• Ongoing Expenses
Your company must engage a registered agent, pay the initial incorporation fees, and then pay the ongoing fees imposed by many states.
• IRS Scrutiny
Because S Corps allow flexibility in how the company distributes profits, the IRS scrutinizes their returns.
• Reclassification Risk
If the IRS finds errors on an S Corp return, it can force you back into C Corp and double taxation status.
How to Create an S corp
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- Determine a legal name and reserve it with the Secretary of State (if your state offers this service)
- Prepare and file the Articles of Incorporation with the Secretary of State’s Office
- Issue stock certificates to all stockholders
- Submit applications for any required business licenses
- Obtain an EIN by applying online at IRS.gov or filing Form SS-4
- Apply for any other ID numbers required by state- and local governments
- Obtain tax ID number for Social Security, unemployment, and disability payroll tax contributions.
- Become aware of any legally required contributions, such as unemployment- and disability insurance
- File IRS From 253 Within 75 days of forming the corporation
The Bottom Line
S Corps offer tax savings, limited liability, and flexibility. Because of this, they are a popular choice for small businesses. However, hiring a tax professional is advisable because the IRS scrutinizes S corp returns and can revert the company to a double-taxed C Corp if mistakes are discovered. Selecting the right business structure begins with understanding the advantages and disadvantages of different entities so make sure to seek the advice and services of an experienced CPA and Accounting Firm.
Proper Tax Planning for Your Business
Make sure your business is running successfully with proper tax planning, preparation, and organization. The accounting and tax services of Tax Avenger in Canton Michigan can make this happen. With over 18 years’ experience, our CPA / accounting firm is dedicated and committed to providing exceptional service to our clients and helping businesses grow. Our services include business accounting and payroll services, individual and business tax preparation, tax problem resolutions and more! Call us today for a Free Consultation!