If you are opening a new business in California or looking to expand an already existing business, do you know what benefits an S-corp can offer your small business?
What is an S-Corp?
A Subchapter corporation or Small Business Corporation often referred to as an S-corp, is an IRS tax classification. The “S” in the ‘S-Corp’ refers to Subchapter S in Chapter 1 of the Internal Revenue’s Service’s tax code. An S corporation is a corporation that is treated as a pass-through entity for federal tax purposes. In order to choose S-corp status, a business must meet certain IRS criteria. To qualify the business must be a domestic business entity, it is limited to no more than 100 shareholders who must be U.S. citizens or legal residents of the United States, and is limited to only one class of stock. Although these criteria cover the federal requirements, your state or municipality may have additional rules.
In order to declare your small business as an S-corp with the IRS, there are certain steps that must be taken. First, you must fill out and file the form for Articles of Incorporation with your Secretary of State’s Office. This form lists the name of your business, address, purpose, and incorporators. Next, you must file as an S-corp with the IRS after your state has accepted your Articles of Incorporation and approved your business name. The form that you must complete with the IRS is known as Form 2553, Election by a Small Business Corporation. The form must include the signature of each shareholder before it is submitted to the IRS and you must file the form prior to March 15 of the tax year in which you are converting to an S-corp. While you are waiting on approval by the IRS to determine that your business meets the eligibility for S-corp status you must also obtain all necessary state and local permits for opening a business.
Advantages of an S-Corp
For small businesses, the advantages of forming an S-corp are the tax advantages and liability protection which also preserves ownership flexibility. Some of those advantages include the following:
- Pass-through taxation means that the S-corp does not pay federal taxes at the corporate level. This protects the owner from the double taxation that C-corp owners face. Instead, business profits pass through to the shareholder’s personal tax returns. Furthermore, the owner of an S-corp has the ability to pay themselves a salary. Of course, the salary that the owner elects to pay themselves must be reasonable and will incur payroll taxes. A further perk is that any owner’s withdrawals or dividends are taken out of the company are free of employment taxes and not subject to a corporate tax rate.
- Personal liability protection is another benefit of choosing an S-corp. Since your personal assets are legally separate from your business assets, you enjoy a certain legal protection
- An S-corp has a lifespan independent of that of its owners. In other words, no matter who the S-corporations owners are at any given time the business can continue to operate regardless of whether a shareholder dies or retires.
- The ability to see the level of commitment made to the company by the owner of an S-corp can lead to heightened credibility in garnering potential customers, vendors, employees, and partners.
Disadvantages of an S-Corp
While there are many advantages to a small business pursuing S-corp status, there are also some disadvantages as well which should be considered in determining whether an S-corp is right for your business. Some of those disadvantages include:
- Strict requirements and limitations require an S-corp to establish the calendar year as their tax year and the reasonable salary requirement based on market conditions. Businesses classified as an S-corp that violate the rules can end up facing penalties such as double taxation.
- Not recognized in every state which could result in your business being treated as a traditional corporation and thus incurring various fees and taxes.
- Corporate rules and protocol include logging your meeting minutes, filing state and federal reports, and meticulous record keeping to name a few. For the novice business owner not familiar with finance management this may necessitate hiring other experienced professionals in the financial industry to ensure compliance with the law such as a bookkeeper, accountant, or tax professional.
For further guidance in determining whether an S-Corp is right for your business, contact our team of experienced business attorneys today.