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S corporation is very popular among solopreneurs and professionals.
Most business owners sort of "graduate" from an LLC to an S corp over a period of time.
In this guide, we will understand what exactly an S-Corp is and its benefits
At the end of this guide, you'll be able to decide whether an S-Corp is right for you or not.
Let's dive right in.
S-Corporation, aka S subchapter is a tax classification made by companies that allow income & losses to be passed through to the shareholders.
It is a tax classification and not a new business entity.
It is just an election that can be made by one of the existing business entities: LLC, C corporation or partnership.
If you meet the requirements set by the IRS and file Form 2553, your business entity can be elected as an S-corp.
It is sort of like a combination of partnership and a corporation: it has flow through income like a partnership and hires shareholders as employees like a corporation.
Now, why would anyone want to be an S-corp?
A couple of important reasons.
Since all the incomes & losses are passed on to the shareholders, federal income tax is levied only once at the individual level.
If you are making quite a bit of net income ($60k+), then you'll start getting the tax benefits of being an S-corp. If your annual income is lower than that, you may not get the most out of it.
LLC, partnership and C corporation are the types of entities that can elect to be an S-Corp.
Owners of these entities will become the shareholders of the S-Corp after election.
They are more than just shareholders. IRS requires the S-Corp to hire shareholders as employees and pay them salaries.
So, the shareholders get 2 types of income from an S-Corp:
Because of this dual nature, not every LLC/Partnership/C corp can be elected to be an S-Corp.
There are some eligibility requirements to be an S-Corp. They are:
Now, that we have seen who can own an S-Corp, let's understand why one should consider an S corp.
S-Corp, at the entity level, pays 2 types of taxes: Payroll tax and franchise tax.
Individual shareholder pays another 2 types of taxes: Self-employment tax and ordinary income tax.
Taxes are paid to the federal and state governments.
Depending on the state of incorporation, total assets and issued shares, tax treatments can vary.
Social security tax, medicare taxes and unemployment insurance are collectively referred to as 'payroll taxes'. S-Corp pays this when there are employees.
Half of this tax amount is collected from the employee's paycheck. And the other half is contributed by the company.
Form 941, Employer's Quarterly Federal Tax Return is filed to report income taxes, Social Security tax, or Medicare tax withheld from employee's paychecks.
Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return is filed as well.
Most states charge an annual fee, often called as "franchise taxes", "renewal fees" or "annual registration fees". This could be fixed, or variable depending on the S-Corp’s authorized shares and assets. States have different methods of calculating franchise taxes. Some states don't charge franchise tax at all.
In addition to this franchise taxes, almost all states have a small annual report fee that has to be paid while filing a mandatory annual report.
Also, excise taxes are typically imposed on manufacturers and retailers of goods and services. Not very common, however still important to many types of businesses.
Though S corporations don't pay any federal income tax, they have to file Form 1120-S(US Corporation Income Tax Return) annually. It reports the income, losses, dividends of the shareholders. Form 1120-S is simpler than the tax forms for a corporation.
And for every shareholder Schedule K-1 is prepared, which is attached to Form 1120-S. It identifies the percentage of shares owned by each shareholder.
As an individual, shareholders have to file Form 1040 to report their individual incomes and losses.
This is paid on incomes from both Distribution and Salary.
Self employment tax is paid on shareholder's salary.
It is not paid on their distribution income, though. That's where the tax savings is.o, excise taxes are typically imposed on manufacturers and retailers of goods and services. Not very common, however still important to many types of businesses.
Taxes are not to be paid once at the end of the year.
Sorry to break it to you. That’s not how it works.
You will have to estimate the annual income for each shareholder ahead of time and split it into 4 quarterly payments to the IRS. This is referred to as estimated taxes.
IRS is pretty serious about this.
They charge a penalty if you fail to pay an instalment or pay it late.
So, keep this in mind.
Use Form 1040-ES to figure and pay your estimated tax.
Below are some of the common tax rates applicable to an S-Corp.
Some of these numbers will vary depending on your exact business situation.
Take this only as an approximate figure.
Alright, it's time to pay yourself.
There are 2 ways of paying yourself as a shareholder in an S-corp: Salary and Distribution.
There are some tax benefits associated with distribution income and that's one of the key reasons for choosing a S-Corp.
Let's see them in detail.
Unlike an LLC, it is mandatory for shareholders to be hired as employees in an S-Corp.
This means, shareholders get a salary.
This salary is considered as an expense for the S-Corp. When it is paid to the shareholder, this is subject to both income tax and self employment taxes. On the other hand, distributions is subject to only income tax.
Because of this, people try to reduce their tax liability by keeping the salary unreasonably low.
This is dangerous. Because, IRS requires you to give yourself a 'reasonable' salary. They have not clearly defined what is 'reasonable'. But think of it like the salary you would have given to another person who were to do your job.
And if you're found guilty of not paying a 'reasonable' salary, you could get fines and backtaxes.
After salary deduction, earnings from the S corp is passed through to the shareholders as distributions.
It is not taxed at the entity level, but it is subject to personal income tax at the shareholder level. No self employment tax here.
There are different types of costs involved in an S corp.
And it depends on a lot of factors: state of formation, nature of business, etc.
Below are some of the ones you could incur:
You can definitely hire employees in an S-corp.
S-Corp is simple enough for you to hire employees and complex enough to protect you in case of employee lawsuits.
Hiring comes with a few responsibilities, though.
Let me repeat.
S corp is not a new business entity. It is just a tax election made by an LLC/Partnership/C Corp.
So, you technically can't "form" an S-corp.
Wherever your LLC/partnership/corporation is registered, that's your state of formation.
As a rule of thumb, if you have a physical office or an employee located in the US, pick that state. For example, if you have a boutique shop in California, where you sell your goods, pick California.
If you have an e-commerce store that you manage online, but you stay in Texas, pick Texas.
Why should you pick the state where you have a physical store?
Because if you're doing business in a state outside the state of formation, you'll have to file a foreign qualification in the "outside" state, in addition to your existing state of formation.
For example, if you are incorporated in Delaware, but end up having a store in California, you'll have to register your corporation as a 'foreign corporation' in California, in addition to Delaware.
That’s 2 states. 2 times the cost.
If you're planning on raising venture capital or get acquired, you may want to consider incorporating in Delaware even if you're not doing business in Delaware. This is because Delaware is very business friendly and the legal system is one of the most advanced. Most investors "require" companies to be a Delaware corporation.
Once your LLC or corporation is up and running, you will come across situations where you may want to change your tax classification to be an S-Corp.
You may want to avoid double taxation or save on self-employment taxes.
On the other hand, you may even want to convert from S-Corp back to an LLC.
Whatever your reason is, let us see some of the common conversion.
Maybe, S- Corp isn't the best entity for you. Maybe it is a C-Corp. Maybe it is an LLC.
Only way to find out is to directly compare them all.
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