CorpNet has helped thousands of entrepreneurs start a business by forming an S-corp, LLC, or other business structure.
Deciding to incorporate a company can be complicated. If you’re trying to choose between forming an LLC or incorporating as an S-Corp, C-Corp or other business structure, keep in mind that each type of company has its own unique requirements, limitations, and benefits.
One of the most popular business structures that our customers choose is the S-Corporation. The S-Corporation has become the most common corporate entity in America, with over 3 million small businesses filing taxes as S-Corps.
If you’ve ever wondered about the advantages of an S Corporation instead of simply forming an LLC, then read on for some insights.
Why is it called an “S” Corporation?
The S Corporation is so named because it is taxed under subchapter S of Chapter 1 of the IRS Code. Basically, this means that S-Corporations have their own unique tax rules, which differ from the taxes you pay with an LLC or C Corporation.
If you decide to incorporate as an S-Corporation, the company itself will not pay taxes. Instead, the taxes are handled by “pass through taxation,” where the earnings “pass through” to the company’s owners and employees.
S-Corporations also ensure limitation of personal liability for the business owners, helping to separate your personal finances and protect your personal assets from those of your business.
What Kinds of Companies Incorporate as S-Corporations?
Under the tax laws governing S-Corporations, these companies can only issue one class of stock (instead of multiple tiers of stock like a publicly traded company) and can only have 100 shareholders or less (unlike big publicly traded companies, which have millions of shareholders).
There are several advantages of doing business as an S-Corporation:
- S-Corps are great for small groups of partners: Since the S-Corporation is limited to 100 shareholders or less, it is an ideal form of business structure for companies formed by small groups of partners. If you don’t expect (or want) your business to grow too fast or too large, forming an S-Corporation is a great way to protect your partners’ personal assets while still enjoying the tax advantages of incorporation.
- S-Corps offer pass through taxation: Unlike C-Corporations, which are expected to pay income tax on their corporate earnings, S-Corporations simply “pass through” their income to their shareholders (owners, founders and employees) and those individuals are then expected to report the income on their individual tax returns. For example, if your business has three shareholders (a founder who owns 60% of the company’s stock, a senior partner who owns 30% of the stock, and a junior partner who owns 10% of the stock), and if the business earns a profit of $300,000 a year, then the founder will earn $180,000, the senior partner will earn $90,000, and the junior partner will earn $30,000, and all of this money will pass through to the owners and employees for them to report as income. The major advantage of S-Corp pass through taxation is that it prevents the shareholders from having to pay an extra share of self-employment taxes, as is the case for sole proprietors.
Although an S-Corp might sound like an ideal business structure if your first concerns are personal asset protection and tax savings, there are a few drawbacks to incorporating as an S-Corporation:
- S-Corps can’t go public: Since S-Corporations are limited to 100 shareholders, it is not possible to use an S-Corp to make an initial public offering. Your company would need to be incorporated as a C-Corp or LLC if you want to become publicly traded.
- S-Corps can’t raise venture capital: Since S-Corporations only can issue one class of stock, they cannot attract venture capital or “angel” investors who often want to receive a “preferred” class of stock with special benefits. This means that S-Corporations are often not the right choice if your goal is to create a high-growth company.
- S-Corps have complications in reinvesting earnings: Most small businesses like to reinvest their earnings in the business – by buying new technology, expanding office space, or renovating the storefront. Since S-Corporations have special tax requirements, it can often be complicated to effectively reinvest earnings in an S-Corporation without shareholders having to potentially pay additional taxes or risk an IRS audit.
NOTE: CorpNet does not give tax advice and this article does not claim to do so. Please talk with a professional tax adviser before making any final decisions about whether to incorporate as an S-Corporation (or other corporate entity) and how to handle your corporate and personal income tax liabilities.