Seeing your small business start to succeed and grow into a well-established company is a dream come true for entrepreneurs. But as your company grows, your tax rate tends to grow too. Growing companies face a variety of complexities during tax season, and that’s why when your company starts growing, you may want to consider forming an S Corporation, otherwise known an S Corp. The S Corp is a business entity that offers significant tax advantages while still preserving your ownership flexibility.
An S Corp, also known as the subchapter or small business corporation, is a tax code that was enacted into law by Congress in 1958. The S Corp was created to encourage and support the creation of small and family businesses, while eliminating the double taxation that conventional corporations were subjected to.
Unlike traditional C Corporations, also called C Corps, the S Corporation is not subject to corporate income taxes. Instead, the S Corporation receives different treatment for tax purposes that is generally more favorable to the business owner. The S Corp is a pass-through entity for tax purposes, similar to the LLC. This means that the income generated by an S Corporation will flow through to the personal income tax returns of the shareholders, and the S Corp itself generally does not owe any tax liability.
Structuring your business as an S Corp also gives you certain flexibility for managing the ownership of the company. The stock of S Corporations is freely transferable, while the interest (ownership) of LLCs is not. This means that the shareholders of S Corporations can sell their ownership interest without obtaining the approval of the other shareholders.
Another area of concern for business owners is reducing their liability for self-employment taxes, and an S Corporation can have an advantage over an LLC in this area as well. To visualize how much an S Corporation can save you in taxes, check out our S Corporation Tax Calculator.
The compensation (salary and bonuses) of S Corporation shareholders is subject to self-employment tax, but not the profits automatically allocated to them as a shareholder. Depending on how you pay yourself throughout the year, and depending on how your income appears on your personal tax return, you can effectively minimize your tax burden by reducing the amount of your business profits that are subject to self-employment taxes. Talk to your accountant or professional tax advisor about the best way to structure your business earnings for tax purposes.
Although the S Corporation offers significant tax advantages and ownership flexibility, it is not the right choice for every business. There are a few restrictions as well.
An S Corporation must adhere to the following limitations:
Depending on your long-term business goals – for example, if you want your company to be publicly traded, or if you want to have international shareholders, a C Corporation might be a better choice of business entity, because C Corporations have no limitations on ownership and can offer multiple classes of stock. But if you are a U.S.-based business and are satisfied to work and grow within these limitations, the S Corporation can save you a lot of money and avoid a lot of hassles as your company expands.
According to the IRS, to qualify for S Corporation status, a business must meet these requirements:
The corporation must also submit Form 2553 to elect S Corporation status for tax purposes.
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