Many enterprises in the U.S. are migrating their business activities from corporations to favorable pass-through taxation. Moreover, as seen in this study assessing business tax payments, the decrease meant lower tax revenues from businesses. They determined that the average pass-through taxation at 19% in 2011 placed revenues at $100 billion lower since the government dropped the business tax average from 28% to 24%. The main benefit of pass-through taxation in the tax-paying structure of businesses is that corporate owners avoid double taxation.

Definition of an S Corporation

TRUiC breaks down the key details of S corporations, making it easier for you to decide if this is the ideal choice for your business. In addition, their free and understandable information and abundant resources make it easier for companies to start a business.

Any LLC or corporation can elect to have an S corporation tax status to receive tax benefits. Knowing what is an S corporation makes it easier for you to decide on its suitability for your startup or existing LLC. S corp owners select to pass their income, losses, credits, and deductions to their shareholders, meaning that the business owner pays taxes as an employee. Therefore, they don’t pay self-employment or income tax on their business earnings but pay them on their salary and income tax on distributions.

Creating an S Corp Tax Designation

The first step requires that you form an LLC or corporation. However, TRUiC doesn’t recommend starting a corporation because an S corp negates the benefits provided by a corporation. You can also opt to convert an existing LLC into an S corp.

Follow the TRUiC guide to the six easy steps to create an LLC. Next, the directors adopt bylaws during the organization meeting and decide on the officers. In the final step, when you request an employee identification number (EIN) from the IRS, you can also file form 2553 to elect the status of an S corp. You can also opt to have a good business service provider undertake the process, making it even easier.

Advantages of an S Corp

Firstly, shareholder liability protection from business is the same as any corporation, and distributing appreciated property of the S corporation to shareholders increases their stock in the corporation.

All distributions to shareholders are free from any payroll taxes, and earnings are only taxed once, circumventing the double taxation of corporations. The same applies when the S corp is sold, the shareholders pay tax on the distribution and are not paid twice by them and the corporation. In addition, if the S corp accumulates earnings that it doesn’t distribute to shareholders, it is not subject to paying accumulated earnings tax which the C corps pay. Lastly, Passive income to shareholders that don’t participate in the company can offset passive losses.

Disadvantages of an S Corp

There are several disadvantages or conditions for establishing an S corp. First, you need a legal business formation with articles of incorporation in your state. Your LLC will have the added expense of an annual report or franchise tax in some states.

The business must earn enough to pay a reasonable salary to the owners, according to the market standard for the work they provide. It must also make distributions, and TRUiC has calculated these at about $10,000 if the S corp is to have any tax savings. The accounting and payroll costs may outweigh the tax savings for the LLC.

There are also stock ownership restrictions. One of these is that the company cannot have more than 100 shareholders, and it can only issue one class of stock. Additionally, the S corp’s owner cannot be another business entity (including trusts or non-profits), only a private individual, and  must either be a U.S. citizen or have permanent residence.

One other drawback is that the IRS scrutinizes all payments to shareholders to ensure they conform. There is less flexibility when allocating income and losses to shareholders since there is only one stock class.

Final Thoughts

Deciding on giving your LLC an S corp tax status requires some thought to ensure it can meet all the costs and restrictions. However, if it does, the benefits can outweigh any disadvantages, allowing you and your shareholders to benefit from the pass-through taxation.