When establishing a business, you must determine the company structure you want to adopt, which could be a long and tedious undertaking. S Corporation is one of the structures you can choose from, but you have to understand what it is and its advantages to your business.
Also known as S subchapters, S Corps are businesses elected for S Corps via the IRS after meeting specific Internal Revenue Code requirements, like:
- Being domestically incorporated within the US.
- Having less than 100 shareholders who meet specific eligibility requirements.
- Possessing only one stocks class.
S Corps status grants business incorporation benefits while also receiving tax-exempt benefits of partnerships and sole-proprietorships. Some of the benefits of running an S Corps include:
Liability Protection
When running an S Corps, your personal assets are separate from the business’s assets. This grants you protection against the business’ liability because suppliers or lenders cannot go after your personal assets to pay loans or debts.
It also protects you against any losses the business might incur as they are locked within the company. Liability protection, however, is not total protection, and you can still face legal action if your personal actions affect another business or individual.
Tax Benefits
Since S Corps are pass-through entities, they don’t pay taxes on the same level as other corporations. Pass-through taxation allows the business to pass the company’s profits or revenue to the shareholders as dividends or salary, provided they don’t exceed the shareholder’s stock basis.
If the dividends transferred to the shareholder exceed their stock basis, the excess is usually taxed as capital gains. However, the tax is lower than the tax implied in ordinary income.
This allows you to lower self-employment tax, which sole proprietorships and partnerships pay large sums of, helping you save in the long run. You can also subtract the paid salaries when calculating the income you will pass through to the shareholders.
Straightforward Ownership Transfer
In an LLC or partnership, transferring over 50% interest can result in the entity termination. Even when transferring acceptable amounts of shares, the shareholders are exposed to adverse tax consequences.
This is not the case in S Corps, shareholders can adjust property basis or transfer interest without complying with complex accounting regulations or facing extreme tax responsibilities.
If your business grows and meets the qualifications of a typical corporation, it’s also easy to convert. All you need is to file for the conversion election with the IRS.
This is unlike converting from an LLC to an S or C corporation, where business owners must comply with the LLC and state corporation laws. You also have to file certain documents with your state.
Cash Basis Accounting Method
Typical corporations use the accrual accounting method unless they are classified as small corporations. Small corporations usually have gross receipts of below $5,000,000. On the other hand, S Corps uses the cash basis accounting method.
In the accrual accounting method, the business recognizes expenses and revenues when they occur, but in the cash basis accounting method, they recognize the two when there is an exchange of funds. Since the accrual method does not track cash flow, you might not recognize a cash shortage in the short term, leading to later losses.
However, the cash basis method allows S Corps to track real-time cash flow, identifying any shortages as soon as they occur. This increases the organization’s chances of correcting the mistakes and remaining in business.
Increased Credibility
Applying for the S Corp status shows the public your dedication to the business because of the formal commitment. This makes it easier for you to increase your credibility among your employees, customers, partners, and clients. In turn, it helps increase sales and gives you a competitive advantage.
Conclusion
An S Corp helps you save on self-employment tax by allowing you to pass through the business revenues and profits as salary and dividends to your shareholders. It also protects your personal assets from the business’s liabilities and gives you easier ownership and conversion options.
While an S Corp has many advantages over corporations, partnerships, and sole proprietorships, the application process can be as long as that of opening any other business. Therefore, you have to research your state’s process, requirements, and qualifications because they might differ from state to state.
Some of the basic things you have to do include choosing a business name, appointing your board of directors, filing incorporation articles, and writing and filing corporate bylaws.
