Advantages of an S corporation
Personal Liability Protection
Shareholders receive personal liability protection. This means, your personal assets can't be taken to satisfy business-related debts. In addition, if the s corporation is sued, your personal assets are insulated from such law suits.
Electing S corporation status is simply a tax election. It allows shareholders to be taxed on S corporation net income at the individual level on Form 1040. The legal status of the entity under the respective state statutes where the entity was originally formed does not change.
FICA Taxes Can Be Reduced
As an S corporation shareholder/employee, you must have social security and Medicare taxes withheld from your salary just like any regular employee.
The S corporation must then match the amount of social security and Medicare taxes withheld from your gross pay.
You can save money on FICA taxes by paying yourself the lowest reasonable salary.
- The lower your salary, the lower your FICA taxes; the lower the FICA taxes withheld from your pay, the less the S corporation must match and subsequently pay to the government. More money is left in the S corporation's bank account.
- But be reasonable here because if if the IRS suspects you're simply trying to avoid employment taxes, they can reclassify your distributions as salary expense and get you to pay all related employment taxes, plus interest and penalties. However, if your business is new and isn't generating much income or is losing money, a low salary in relation to what would normally be paid to a person doing similar work in the marketplace, can be justified. As you can see, this is a tricky area and calls for reasonableness and good judgment.
If you need additional income, you can take it out of the S corporation as a non-dividend distribution (as opposed to a dividend distribution that only regular C corporations pay out to shareholders).
Keep in mind, unlike distributions to shareholders by a C corporation from retained earnings, which are dividends and require the C corporation to issue Form 1099-DIV to shareholders and the IRS, S corporation distributions to shareholders are not considered dividends and do not require a Form 1099-DIV to be issued.
There are some exceptions, however. For example, if the S corporation was a C corporation prior to converting to S status, and at the time of conversion the C corporation had retained earnings. Distribution of those retained earnings would be classified as dividends and Form 1099-DIV would have to be issued to shareholders and the IRS to account for the distribution.
S corporation net income, whether or not actually distributed, is included in each S corporation shareholder's gross income via Schedule K-1 issued annually, according to his percentage ownership of the stock of the company (i.e. 50%-50% owners each share 50% of all income, deduction, credits, gains, and losses of the S corporation).
Double Taxation Avoided
The pass-through feature of an S corporation is what makes it possible to avoid double taxation of income.
Income is taxed directly to shareholders, even if not distributed. In contrast, C corporation income is taxed to the the corporation first, then, to shareholders, but only if it is distributed to them as dividends.
Losses are Deductible
S corporation shareholders get to deduct losses against other income reported on their individual income tax returns. For a new business, where losses are common the first year or two, this can prove to be a real tax saver.
The amount of loss you may deduct is limited to your stock basis plus your loan basis. Only loans made by you to the corporation for which you are personally liable count. Loans made by others that you guarantee don't count.
In contrast, C corporation shareholders may not deduct corporate losses (net operating losses and net capital losses).
The corporation deducts:
- Net operating losses (NOLs) against net operating income of other periods.
- There are a variety of carryback and carryforward periods for NOLs.
- Net capital losses are deducted from capital gains. Capital losses are carried back 3 years and forward up to a maximum of 5 fives years (after that they're lost).
Disadvantages of an S corporation
Setting up a corporation may cost hundreds or even thousands of dollars in legal, accounting, and filing fees. Then, there are the ongoing legal and accounting fees to comply with state corporation laws and federal and state tax laws.
- Return to the Tax Basics for Startups Table of Contents to find related links.