An S corporation is another type of corporation which has similarities to both C corporations and Limited Liability Companies (LLC). It is kind of a hybrid alternative available for the modern day businessmen in which they are entitled to the benefits of both these forms of business.
In order to create an S corporation, the proper formation documents procedure has to be followed. First the articles of incorporation or certificate of incorporation must be filed with the appropriate state agency along with the necessary state filing fees being paid. This will complete the creation of the corporation at the state level. However for the tax implications to be effective a filing with the Internal Revenue Service (Form 2553) is necessary. Upon the receipt of the permission by IRS, which may generally take at least 60 days, the entity will be elected to S corporation status.
However S corporations are subject to certain restrictions stipulated by the IRS. As a result the shareholders of an S corporation must meet the following criteria:
- Number of shareholders must be lesser than or equal to 100
- Shareholders need to be U.S. Citizens
- All shareholders must vote in favor of the S corporation
- The entity cannot be C corporations, other S corporations, Limited Liability Companies, Partnerships or certain Trusts.
Having understood the legal procedure and requirement let us now move on to the pros and cons of an S corporation.
Tax Benefits:
One of the main advantages of S corporations is its ability to pass through the profits and losses to the owners. This means while the individual shareholders may get taxed for the portion of profits they receive, the S corporation as a separate entity will not be taxed. This is not the case with C corporations where the both corporate entity as well as individual shareholders will be taxed. Although this is the case with most of the states there are some exceptional states which tax S corporations similar to the C corporations. So check your state tax laws prior to the decision.
One can argue that it is not only the S corporations, Limited Liability Companies (LLC) also enjoy this pass through tax benefit. But an S corporation still has an edge over an LLC in the area of self-employment taxes. Although the compensation of the shareholders of an S corporation is subject to tax, the allocated profits to them as a shareholder are not taxed. But this is not the case in an LLC.
In addition to that certain S corporation business expenses may be tax deductible.
Limited liability and unlimited life:
Shareholders of an S corporation are not personally responsible for the debts and liabilities of the business. They carry limited liability which is only for the value of the shares they own. Further the ownership can be easily transferable to someone else through the sale of stock. S corporations have unlimited life extending beyond the illness or death of the owners.
Other:
Since it is a corporation the potential customers may perceive it as a more professional entity than a sole proprietorship or a partnership. Further in practice, S corporations are less frequently audited compared to these entities. Apart from the advantages discussed up to now, S corporations can raise finance through selling shares at any given time through private placements as well.
Let us now move on to the drawbacks of an S corporation.
Subject to restrictions
As already discussed above S corporations are subject to numerous regulations and requirements. For instance the number of shareholders should be less than or equal to 100.
Formal Procedures
Similar to C corporations these also should set up and maintain certain corporate formalities which can be quite costly.
Scrutiny on shareholder-employees
As we discussed under the advantages the profits distributed to the shareholders are exempted from self-employment tax. Therefore many S corporations attempt to manipulate this clause by reducing the compensation to the employee-shareholder (which is subject to tax) and increasing the distribution through profits. As a result the IRS exercises close scrutiny on the shareholder-employees who must receive reasonable compensation before any non wage distributions may be made.
|
