When starting a business and choosing your structure, you might hear about S-Corps. While there are benefits to selecting an S-Corp tax status, there are also disadvantages.
What is an S-Corp?
It’s important to point out that an S-Corp is not actually a business entity — it’s a tax election. Both LLCs and Corporations (which are business structures) can make an S-Corp election, which means they choose to be taxed under special rules within the IRS Code.
Even after making the election, the business will remain an LLC or Corporation. All that changes is the business’s tax status.
The biggest benefit of being taxed as an S-Corp is that business owners can reduce their tax liability in certain situations. In short, the owners must pay themselves a reasonable salary, on which they pay all regular employment taxes (roughly 15%). They can then distribute profits above those salaries, on which they don’t have to pay regular employment taxes. This means they can save about 15% on those profit distributions.
(Note: This is a very simplified explanation of the tax benefit. You should absolutely talk with an accountant or lawyer about your situation before relying on this summary.)
If you make an S-Corp election, you’ll be required to pay yourself a salary. This means you’ll need to set up and run payroll and withhold/remit taxes for the state and IRS. You can have an accountant do this for you or use an online provider like Gusto. There are also additional tax filing and payment obligations. This all adds up to additional expenses for your business.
Moreover, you must take extra precautions to make sure you don’t violate any S-Corp restrictions. According to the IRS, to qualify for S-Corporation status your business must: (1) be a domestic corporation or LLC, (2) have only allowable shareholders, (3) have no more than 100 shareholders, (4) have only one class of stock, and (5) not be an ineligible corporation.
If your request for S-Corp status is approved, but you later violate one of those rules, you can lose your S-Corp status and suffer negative tax consequences. Thus, you should take steps to avoid accidently losing your S-Corp status like including special rules in your LLC Operating Agreement or Corporate Bylaws or Shareholder Agreement.
When an S-Corp Might Make Sense
Generally, if you run a small business without professional investors and your ownership structure is simple, an S-Corp might be a good move for you. However, this is only true if you are doing well financially and earning more than a reasonable salary.
Conversely, if you have a complicated ownership structure, plan to take on professional investment, or have ambitions of “going public” in the future, an S-Corp is probably not a great idea. Additionally, an S-Corp election likely wouldn’t make sense if you are not making more than a reasonable salary.
Also, if you make an S-Corp election, you generally won’t want to revoke it because there may be negative tax consequences if you do. Thus, make sure the election is in your long-term best interest before making it.
How to Make an S-Corp Election
First, you should always talk to an accountant and a lawyer before making this decision. To make the election, submit IRS Form 2553 to the IRS. You should do this shortly after you create your company, or at the start of any calendar year.
This article is general in nature and is not legal advice. You should speak to a licensed attorney about your unique circumstances before relying on this article.
Chris Brown represents startups, freelancers, and small businesses through his law firm, Pixel Law. He also co-founded Contract Canvas, a digital contract platform for creative professionals. You can find him on Twitter @thepixellawyer.
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