10 Important Things You Need To Know About S Corps

 

One of the key decisions you make as a business owner is choosing the right business structure. This impacts your legal and tax obligations and may offer additional benefits or protection against liabilities.

One of the common business structures is the S Corporation (S Corp). But what exactly is an S Corp and what are some important things you need to know if you are considering changing your business structure to an S Corp?

In this article, I share the benefits of becoming an S Corporation, some considerations to keep in mind, and how to make the best decision for your company.

 

What is an S Corp?

“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” – Internal Revenue Service

An S Corp is considered a pass-through entity. This means the income and losses of the S Corp “flow through” the company to its shareholders. The shareholders then report these profits and losses on their personal tax returns. In this way, S Corps avoid having to pay taxes twice on the corporate income.

 

S Corp Requirements

To become an S Corp, the company must fulfill certain requirements. It must be a domestic corporation and have no more than 100 allowable shareholders. Shareholders must be individuals, certain trusts, and/or estates. They cannot be partnerships, other corporations, or non-resident shareholders. S Corps can also only have one class of stock.

Certain corporations like financial institutions, insurance companies, and domestic international sales corporations are ineligible to file for S Corp status.

 

Benefits of Having an S Corp

Like any other business structure you may choose, there are certain advantages of having an S Corporation.

 

Limited Liability Protection

An S Corp offers you, as the owner of your business, protection on your personal assets. Unlike in a sole proprietorship where you are personally responsible for the debts and liabilities of your company, this is not the case in an S Corporation. If the company has outstanding debts or liabilities, your personal assets like a house, car, or cash in the bank will not become vulnerable.

 

Zero Tax at Entity Level

The S Corporation is a pass-through entity, meaning all profits and losses flow through the corporation and are recorded on your individual tax return (Form 1040). Your company will not be liable for taxes at the entity level – only at the individual level. As such, the S Corp avoids double taxation. 

 

Bypass Self-Employment Tax

At roughly 15.3% of your annual income, self-employment tax can be a hefty sum to pay. As a shareholder and employee of an S Corp, you can bypass this self-employment tax and make some savings on your tax bill. The caveat is that you will now have to pay yourself on a W2 and are liable for payroll tax instead.

 

Tax Savings Through Salary and Distribution Payments

As the owner of an S Corp, you can choose to receive the profits of the company as distribution payments in addition to your salary. This can help reduce your individual tax bill as distributions are not subject to additional tax. Do note that the IRS places strict regulations on the wage compensations for S Corp employees and closely monitors the division between salary and distributions to ensure they are “reasonable”.

Additionally, the S Corporation can deduct your salary as an expense on the income earned to calculate the final amount payable to shareholders. This also results in lower taxable income and more tax savings. 

 

Greater Credibility

If you have ever struggled to get a loan from a bank as a sole proprietor, you’ll appreciate the credibility that comes with having a W2 form. As a salaried employee of your S Corp, you can more easily get loans from banks simply by producing your W2 form that shows all your income earned that year.

 

From a business perspective, S Corporations are also viewed as more legitimate and reliable than a sole proprietorship. This may help you land more clients, build better partnerships with vendors and contractors, and even hire top-quality employees as your company grows.

 

When to Consider Becoming an S Corp

Based on all these benefits, it can be tempting to jump in and file to become an S Corp. However, not every company should immediately file to become an S Corp! In fact, depending on your individual tax situation, becoming an S Corp may turn out to be a financial drain instead.

 

You may have heard the common advice: If you are making $50,000 in net profit, it is time to consider becoming an S Corp. However, figuring out if turning your company into an S Corp is the best option for you is not that straightforward.

 

Your tax liabilities can vary depending on:

• Your filing status: Tax rates vary drastically depending on your filing status. For example, if you are filing as a married person or head of household, your tax liability may be much lower than someone filing as a single person. In this situation, your tax bill might be higher if you were to turn your company into an S Corp.

 

• Do you have a W2? This can impact your final tax liability if you are earning employment income from another source as it may put you in a higher taxation bracket.

• Do you have children or other dependents? Children and other dependents give you tax credits and deductions, which help to lower your final tax bill. This can give you more wriggle room about when to change the status of your company to an S Corp.

 

With these additional factors to consider, it is a good rule of thumb to speak with an accountant or tax specialist when your business reaches the $50,000 in net profit milestone. A financial professional will be able to look at your specific situation to advise you on your best course of action.

 

The Exceptional Tax Services Approach to Filing for S Corp

At Exceptional Tax Services, we are committed to helping you make the best possible financial decision for you and your business. That’s why when you come to us to change your business entity to an S Corp, we don’t blindly file the paperwork.

First, we assess your personal tax situation and gather information about your tax situation, including filing status, income, credits, deductions, and more. Based on that, we create detailed projections that show your tax liabilities in your current business structure and as an S Corporation.

 

In our projections, we do not simply show you the differences in taxes owed.

 

When you file to become an S Corp, there are additional financial obligations you may not have considered. As an S Corp, you need to pay compliance costs to maintain your status as an S Corp. You may also need to pay additional accounting fees to file two tax returns (S Corp and individual). You will need to take into account the owner’s salary and associated payroll costs (e.g. platforms like Gusto (*Affiliate link) to manage payroll). There are also Accounting fees to get set up as an S Corporation.

Projecting these additional costs together with the tax benefits will give you a clearer picture of whether filing for an S Corp is worth it and allow you to make an educated decision to move forward.

 

*Affiliate Link: Gusto is our recommended software for payroll and we use it with our clients. If you sign up for this service using this link, we earn a small commission at no additional cost to you.

Are You Ready to Become an S Corp?

If you think your business is ready to become an S Corp, don’t hesitate to reach out to Exceptional Tax Services. We will help you run the numbers so you can make the decision confidently – and we’ll guide you through filing the paperwork too! Book a call to get started or learn more about S Corps in the All about S Corporations Mini Course.