A corporation is still the most popular legal structure for bigger business ventures. What makes a corporation stand out is shared ownership among multiple members and no liability for the shareholders for the company’s actions and problems. Similar to LLCs, corporations can be set up by individuals and legal entities alike. Yet, the company equity split is a bit different. Instead of capital contributions for LLCs, corporations issue stock and so-to-say sell it to the company members. This is also the easiest way to raise financing and engage investors when there is a need for added funds to finance business growth. In the meantime, unlike in LLCs, member shares in corporations are allocated strictly pro-rata to their financial infusions and the number of shares they own. As a legal structure, corporations are further divided into subtypes by the taxation approach. Thus, they distinguish between C-Corporations and S-Corporations. The latter is widely popular among startups and growing businesses.
Below, we’ll explain the benefits and drawbacks of S-Corporations and what business perspective this type of entity offers.
Subchapter S Corporation Definition
What is an S-Corporation? First off, an S-Corporation, Subchapter S Corporation, or an S-Corp as they call it is not simply a “smaller corporation”. It’s a sort of tax status assigned to the corporation by the Internal Revenue Service under the subchapter S, hence the name. In other words, an S-Corp is a corporation that mixes the benefits of a corporate business with the perks of pass-through taxation. In this case, the company owners are relieved from the heavier tax burden of C-Corporations. The company profits are transferred to the personal tax returns of its owners, and income taxes are paid under their individual tax rates. This is what makes S-Corps so appealing for smaller business owners and allows for optimized taxation so that you could better maintain your business growth at the start.
Historically, a subchapter S as a part of a tax code for corporations came into effect in 1958 to promote and maintain small business and family ventures by providing them with more favorable tax conditions. And this is what still gives S-Corps an edge over other entity types today and makes this legal structure so attractive for smaller business owners.
It’s worth noting that to file for an S-Corp status, there are certain requirements your newly-formed corporation should meet:
- The business should be formed as a domestic or home corporation, i.e. operating in the state of formation;
- Eligible S-Corp shareholders are individuals and legal entities, which are US residents. Non-residents and foreigners are not allowed to be S-Corp owners;
- An S-Corp can issue only one class of stock;
- The number of company shareholders should not exceed 100 persons, where husband and wife are considered as a single shareholder;
- Financial institutions, insurance agencies, and home sales corporations are usually not permitted to qualify for S-Corp status.
Advantages and Disadvantages of Filing Under Subchapter S
As with any other entity type, a Subchapter S Corporation has certain pros and cons to it. Thus, it mainly owes its popularity to a smart combination of limited liability protection with pass-through taxation. This way, corporate members are exempt from dual taxation by paying taxes only at a personal level and avoiding corporate withholdings. At the same time, they still have no personal liability for the company’s financial problems, debts, and lawsuits.
Other tax advantages pertinent to S-Corps include income tax reduction by cutting down self-employment tax payments through classifying the owner’s income as a salary. Besides, S-Corps are enabled to deduct some business-specific expenses from the taxable income, thus, reducing the whole revenue to be taxed by about 20%.
At the ownership level, S-Corporations can be legally designated by sole individuals. This entity status greatly enhances overall business credibility and trustworthiness with potential customers, creditors, sponsors, traders, and suppliers. Unlike LLCs, S-Corps are set up for perpetual existence and boast easy transfer of ownership, with no complicated procedures to follow and routines to complete. In the meantime, the personal assets and belongings of shareholders remain securely protected from the risk to be collected to set off the company’s financial liabilities.
When it comes to S-Corp disadvantages, this type of corporation should still follow complex corporate rules related to the company management and operation and observe strict compliance regulations. Should any violations or breaches in tax payments, wages accrual, expenses accounting, or filing compulsory reports occur, an S-Corp status can be immediately terminated by the state. For shareholders, it results in restrictions of their equity rights and authorities. Yet, the S-Corp advantages obviously outweigh potential downsides, which are easily avoidable subject to maintaining your business in good standing with the state.
S-Corporation Financial Reporting
Thanks to their pass-through tax status, S-Corporations are free from filing federal tax reports and corporate taxes. There will be no income tax expenses on the corporate income statement, and you won’t have to declare business tax liabilities on the S-Corp’s balance sheet. All those tax liabilities will be transferred to the personal tax returns of the business owners. The same is true for the company losses. Notably, business profits and losses are distributed pro rata to the shareholder’s percentage in the company equity. Besides, company owners with no stock are allowed to select a cash accounting method. It will let you pay an income tax only when you obtain revenue and, accordingly, deduct expenses only when those are paid