Should You Form an S-Corp? Pt. 1
Updated: Oct 27, 2020
Part 1 – Business Entity Comparison: S Corp Status vs Corporation
One of the first legal questions a startup’s founder faces is “what business entity should I form?” There are a host of options – including sole proprietorships, partnerships, limited liability companies, S Corporations, and C Corporations – each with its own advantages and disadvantages. Of the various options, S Corps always seem to cause some confusion, likely because of their chimeric traits, combining features of corporations and LLCs.
A good starting point is understanding what an S Corp actually is. An S Corp isn’t truly a business entity. It’s a tax status. In order to have an S Corp, you need to first form a corporation or LLC and then elect to be taxed as an S Corp.
Even if the company meets the requirements, and successfully obtains S Corp status, it’s important to remember that the election is only for tax purposes, not legal purposes. The company does not convert into a new entity. Thus, for example, your LLC cannot issue stock just because your company elected to be taxed as an S Corp.
The entity vs. status distinction is also crucial in determining whether to elect S Corp status in the first place. This is because the benefits and drawbacks of electing S Corp status should be compared against the entity you initially formed. Below, and in the next blog posts, I will examine some of the benefits and drawbacks of an S Corp vis-à-vis LLCs and C Corporations.
Benefits of S Corp Status vs a Corporation
1) Pass-through taxation.
Corporations are subject to what is known as double taxation. Double taxation occurs when an entity is taxed on corporate earnings, and then again at the shareholder level when the corporation pays dividends. This happens because, under the law, corporations are treated as persons. As such, there are two different persons accumulating earnings: the corporation, and the shareholder. When the corporation has income, it is taxed. If the corporation pays a dividend, there is a new, separate person receiving and income, who is also taxed.
Pass-through entities, for the most part, are free from paying taxes on a corporate level. Instead, the income (or losses) they generate are attributed to its owners for tax purposes. Thus, the gains “pass through” the company to the owners, avoiding the first layer of taxation.
However, this benefit is only guaranteed at the federal level. Some states and municipalities choose to impose a tax on certain pass-through entities. For instance, New York City imposes an income tax of 8.85% on corporations, regardless of S Corp status. California imposes a franchise tax on many types of entities, including LLCs and corporations, regardless of S Corp status, of either 1.5% or $800, whichever is greater. North Carolina imposes a corporate franchise tax that is applicable to S Corps, though at the reduced rate of $200 for the first million dollars of the corporation’s tax base and then $1.50 per $1,000 of its tax base thereafter.
2) Qualified business income deduction.
The 2017 Tax Cut and Jobs Act provides large tax deductions for owners of certain pass-through entities. Beginning for the 2018 tax year (and continuing every year through 2025, unless extended by Congress), owners of pass-through entities can deduct up to 20% of their share of qualified business income (“QBI”) from their personal income taxes. QBI is the profit a pass-through entity earns during the year, excluding certain types of income (like dividend income, interest income, short-term or long-term capital gains, wages paid to S Corp shareholders). How much each individual can deduct is determined by through a variety of factors input into a complicated formula. (You can learn more about the QBI deduction here). The savings from this deduction can be substantial.
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In certain situations, an S Corp can provide significant benefits over a traditional C Corp. However, discussing the myriad advantages and disadvantages at the theoretical level, only goes so far. Determining the best choice for a particular business requires an examination of its unique circumstances. In the next part of this series, I’ll compare the benefits of an S Corp to an LLC. Then I’ll wrap the series with a look at some of the disadvantages of forming an S Corp.
If you are trying to decide between various business forms, want to form an S Corp, or have any questions about business entities, don’t hesitate give us a call, or reach out to firstname.lastname@example.org.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.