If you are active in the small business world, you have no doubt heard the term “S Corp.” This term is often thrown around as an alternative to typical business structures, such as LLCs or Corporations. This is not entirely accurate. Very seldom does anyone discuss what an S Corp actually is, its purpose, or why an S Corp may be better than other options. Knowing this information can be instrumental in setting yourself up for long-term profitability, but finding correct information can often be a challenge. In this post, I will clarify some of the most prominent S Corp misconceptions and how S Corp status affects business tax elections.
S Corps Are Not Legal Entities.
The most common misconception is that S Corps are a separate type of legal entity just like an LLC or corporation (commonly referred to as a “C Corp”). This, however, is a bit of a misnomer as there is no legal entity type that is called an S Corp. Rather, S Corp status is a tax election set forth by the IRS which allows the owner of one of the other registered entities to achieve certain beneficial tax structures, if they meet the qualifying criteria. To be an S Corp, you first have to have a registered entity, meaning that your business must be either an LLC or a corporation. A sole proprietorship or general partnership can never elect to S Corp tax status.
Making the S election won’t change the type of legal entity you have at all. Instead, an S election changes the way that the IRS taxes your business. This can have dramatic effects on the company’s taxes and profitability but does not change the other characteristics that are typical of each form of entity. In other words, an S election will not change the management type, limited liability benefits, or other benefits provided by your chosen entity.
S Corps and LLCs are Taxed Similarly, but Not the Same.
From a high level, LLCs and S Corps both enjoy what is referred to as “pass-through taxation.” This means that the IRS disregards the legal entity for taxation purposes and the company’s income passes through the entity and is taxed as if earned by the owners individually. For an LLC this means that the individual owners are then responsible for paying self-employment taxes and those self-employment taxes are incurred on the LLC’s full net earnings. This tax rate varies from year to year, but generally speaking, this can lead to a sizeable tax hit to the business owner.
An S Corp on the other hand requires that the owners of the entity be paid a reasonable salary as opposed to simply taking distributions as LLCs typically do. By paying the owner a reasonable salary, the company is responsible for the owner’s employment tax withholdings, which would be taxed at a lower rate than if it were taxed under the standard LLC method of taxation above. To the extent that there are any net earnings that exceed the salaries paid to the owners, the remaining earnings would be taxed as though they were dividends which also carries a lower tax rate than the standard self-employment tax rate. As such, by engaging in thorough tax planning, an S Corp can greatly reduce its overall tax hit whereas an LLC operating under its default tax classification is much more limited.
You Don’t Need to Incorporate to be Taxed as an S Corp.
As briefly alluded to above, you don’t have to be a corporation in order to be an S Corp. It is incredibly common for corporations to elect to be taxed as an S Corp as the default method of taxation for corporations is referred to as “double taxation.” This means that the corporation’s income is taxed first at the corporate level and then again at the shareholder level. Being taxed twice is obviously not ideal, especially for smaller companies, so being able to elect a different method of taxation can be critical.
This issue, however, is not limited to only corporations. LLCs enjoy pass-thru taxation and while this is preferable to double taxation, it is not without its own shortcomings which were described in the first section of this post. What many people do not know is that an LLC, despite not being a corporation, can elect to be taxed as an S Corp as long as it meets the eligibility criteria. The only real difference between a corporation making an S election and an LLC doing the same is the form that you use to make the election. Otherwise, both types of entities can elect S Corp taxation and enjoy identical tax benefits.
S Corps are Only Slightly Less Flexible than LLCs.
The primary criticism of S Corp taxation when compared to LLC pass-through status is that S Corps lack the flexibility of LLCs. To a small extent, this is true, however, it tends to be greatly exaggerated in modern times. Many of these criticisms pertain to the period of time before LLCs rose to popularity and before LLCs were able to make their own S elections. During those times, S Corps were required to adhere to the same formalities as a normal corporation, greatly limiting the company’s flexibility. These days, an LLC that elects S Corp status can still manage the LLC in the manner it wishes and can largely maintain the same flexibilities as a default LLC. The only considerable barriers then are the IRS’ eligibility criteria and the requirement that LLC owners be paid a reasonable salary, as mentioned previously.
Understanding the differences and benefits of each business structure can help you ensure long-term profitability for years to come. As you consider this decision, it is always best to discuss your questions and concerns with an experienced business planning attorney.
For more information or for advice specific to your business, call Darkhorse Law today to schedule a consult with a business planning attorney. Darkhorse Law is a Virginia-based law firm serving clients nationwide in trademark, copyright, and business matters. Call (800) 279-4292 or message us to schedule a consultation
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