Whether you’re just kick-starting your new business, or you’ve been operating as a sole proprietor for some time now, you may be weighing the pros and cons of incorporating your business as an S corp.
In simple terms, an S corp (also known as an S subchapter) is a qualifying business entity that, for federal tax purposes, passes its income to the shareholders while also giving businesses the benefits of a C corp.
Usually associated with small businesses with under 100 shareholders, S corps offer the liability protection of C corps while maintaining the tax benefits of a proprietorship. Best of both worlds, right?
As a small business owner, it’s important to understand why exactly this election could be so beneficial for your corporation and recognize where the complications lie.
What are the pros of making the S Corporation election?
- Tax Benefits
This isn’t listed as #1 without reason. The monetary benefits are the primary reason why small businesses elect S Corp to begin with. This includes both payroll and income tax savings.
Let’s say Jack started a landscaping company called Evergreen last year and made $1 million. Not too shabby, Jack!
Jack decided to pay himself a personal salary of $250,000. As a C corp, Evergreen will be expected to pay approximately $210,000 in federal income taxes, and Jack will then be taxed on his personal salary as well. But if Jack elects S corp, he passes all of Evergreen’s income to himself, and bypasses a daunting double tax.
If your S corp experiences any loss, (not that it will, you savvy business owner, you), you can also deduct that loss from your personal income since you’re passing all income to your shareholders.
Note: Chat with your accountant to discuss real-world numbers here. The savings will be more significant if your corporate profits are high, while the shareholders incomes are very low.
- Protected Assets
Compared to a sole proprietorship or partnership, a huge advantage to S corp is that it offers your company liability protection. This means that your personal funds (as well as the rest of the shareholders’) are shielded from business creditor’s claims.
What does this mean? Let’s say your small tech company has a security breach and risks customer’s data and funds. Your company will be held responsible, but your personal funds, income, and assets are legally protected. Anyone seeking compensation can only go after the business itself, not the shareholders personally. Phew!
- Elevated Credibility
Who doesn’t love a little credibility boost? You might find that by operating as an S corp, rather than as a sole proprietor, you gain credibility with your customers and the way they view your business. For those in the know, it definitely counts for something.
This doesn’t stop with your customers. S corp allows members to receive cash dividends from company profits, separate from personal income. This acts as a great perk for existing or incoming employees if they choose to own stock in your company.
While there are obviously many reasons why S corp is a great option for your small business, there are also some disadvantages to consider:
The Downside of Filing as an S Corporation
- Hidden Fees
Corporations often face additional bank and legal fees when compared to a sole proprietor. Banks may charge your S corp business more for your checking accounts or loans, and you might need an experienced attorney to handle any new legal fees you could be facing.
You also have to consider that insurance for an S corp is simply going to be higher than that of a sole proprietor. You will likely spend more for the exact same insurance, and many states require a higher minimum when it comes to malpractice insurance.
Keep your eyes peeled for all these extra expenses; they can add up quickly. But hey, not the end of the world when compared to the money you’re saving overall.
- Complicated compliance rules
By federal tax law, in order to obtain and maintain S corp eligibility a corporation must meet extremely specific requirements.
For example, only individuals, specific trusts and estates, and specific tax-exempt organizations can be shareholders. This excludes you from owning other companies and foreign entities.
S corp businesses can have no more than 100 shareholders in general, which could stunt your company’s growth if you’re planning on expanding quickly. It’s also important to note that if your corporation has inventory, you are not eligible to elect S corp at all.
These are only a few of the rules that have to be followed. In order to avoid these restrictions, a good alternative to becoming an S corp would be to become an LLC. This way you can still be a pass-through entity, without being subject to these rules and regulations.
- Additional Tax Accounting
This is arguably the biggest setback when it comes to owning an S corp. As the owner, you will either need to do some serious studying on how to manage the taxes of your S corp, or hire an accountant to take on your new bookkeeping requirements.
Generally, the tax preparations themselves will cost slightly more than when you were a sole proprietor. If you are used to preparing your own taxes, it might be beneficial to hand the more complicated corporate tax documents over to the professionals.
Weigh the pros and cons of S corps against your personal business needs.
At the end of the day, the advantages of electing S-corp usually outweigh the negatives. It is absolutely the right choice for your business if you want the structure of a corporation paired with pass-through taxation.
And if you’re looking to keep more money in your pocket, the rules and restrictions are something that can easily be handed over to your accountant to help you deal with.
Know Your Numbers PLLC is passionate about working with you to figure out the best way to structure your small business. Need advice on next steps? We are happy to sit down and discuss what’s best for your future, S corp or not.
At what point did you start researching becoming an LLC or S Corp? Let us know below!