If you are starting a business venture with some investors and wondering what type of entity to form, an S Corporation may be an effective tax structure. As a practical matter, we should clarify that an S Corporation is not a state law designation. Instead, it is a tax status you elect by filing Form 2553 in a timely manner with the IRS. In general, taxpayers are able to elect S Corporation status for a corporation or a limited liability company formed under state law.
Benefits of an S-Corporation
An S Corporation can offer several advantages that are typically unavailable to other entities which are addressed below.
Protection Against Creditors/Limited Liability
One benefit of using an S Corporation over a general partnership is that S Corporation shareholders are not personally liable for corporate debts. In order to receive this protection, it’s important that:
- The corporation be adequately financed;
- The existence of the corporation as a separate entity be maintained, including separate books and records;
- Various formalities required by your state be observed (e.g., filing articles of incorporation, adopting by-laws, electing a board of directors and holding organizational meetings); and
- Organizational requirements are adhered to, i.e. they:
- must be a domestic corporation; have restrictions on who may be a shareholder — discussed in the section titled “Protecting S status”;
- cannot have more than 100 shareholders (note however, members of family are counted as one shareholder);
- cannot have more than one class of stock; and
- cannot be an ineligible corporation such as certain financial institutions, insurance companies, and domestic international sales corporations.
The organizational requirements noted in line 4 above include necessary items to be treated as an S corporation, but these aren't items to receive protection against creditors. Failing one of these aforementioned items could cause the corporation to be treated as a C corporation instead of an S corporation, but it should still have liability protection under state law.
Ability to Pass-Through Losses & Income Recognition
If you expect that the business will incur losses in its early years, an S Corporation is generally preferable to a C Corporation from a tax standpoint. Shareholders in a C Corporation generally get no tax benefit from such losses. In contrast, as an S Corporation shareholder, you can deduct your share of losses from the S Corporation on your personal tax return to the extent you have basis in the stock and in any loans you made directly to the entity (unlike a partnership, debt incurred at the S Corporation level does not create tax basis for the shareholders to deduct losses). Losses that cannot be deducted because they exceed your basis are carried forward and can be deducted by you in the future when there is sufficient basis. Losses are also subject to other limitations including the passive loss rules and excess business loss rules.
Once an S Corporation begins to earn profits, the income will be taxed directly to the shareholders whether or not the income is distributed. It will be reported on the individual income tax return and be aggregated with income and losses from other sources. To the extent the income is passed through to you as qualified business income (QBI), you will be eligible to take the 20% pass-through deduction, subject to various limitations.
Similar to LLC’s taxed as partnerships, S Corporations can allow owners to elect to pay personal state income tax through the entity and benefit from a state tax deduction on their federal income tax returns.
Note: Unless Congress acts to extend it, the QBI deduction is scheduled to expire after 2025. If you’re planning to provide fringe benefits such as health and life insurance, you should be aware that the costs of providing such benefits to a more than 2% shareholder are deductible by the entity but are taxable to the recipient. Note however, the recipient is allowed a deduction for the health insurance premiums that are taxable against their adjusted gross income.
Ability for Shareholders to Take Wages
Unlike a sole proprietorship or partnership, an S Corporation should pay you a reasonable salary. Your share of excess profit from the S Corporation is not subject to payroll taxes, or self-employment taxes. Furthermore, if you are active in the business, the income is also not subject to the net investment income tax. However, some states like California impose a tax at the S corporation level on its net taxable income (see below).
Ability to Issue Key Employees Stock Options
Similar to C Corporations, S Corporations have the ability to issue Incentive Stock Options (“ISO”) and Non-Qualified Stock Options (“NQSO”) to employees. A stock option is a right granted to an employee to purchase stock of the corporation at a certain price. Employees holding ISOs are not taxed on the shares until they are sold (at which point they are taxed at capital gains rates if the holding periods are met), whereas employees holding NQSOs are taxed when exercised (at which point they are taxed at ordinary income rates and are subject to withholding like wages). As mentioned above in the section titled “Protection against creditors/limited liability”, S Corporations cannot have more than one class of stock or more than 100 shareholders. You should consult a tax advisor or attorney before adopting an ISO Plan or issuing NQSOs.
Potential Step-Up to a Buyer Upon Exit
In contrast to a C Corporation, during an exit from an S Corporation, it is possible for buyer to obtain a step-up in basis for the premium paid. This generally affords you a higher valuation when selling an S Corporation as compared to a C Corporation. The step-up may result in additional taxes being incurred, so your tax advisors would want to negotiate for the buyer to make you whole for extra taxes incurred. Such a step-up transaction does impact the capital gain apportionment for state income tax purposes. Taxpayers who move to states that do not impose an income tax may have increased state tax exposure for entering a step-up transaction with the buyer.
Note: If your new venture is eligible to be considered a qualified trade or business pursuant to IRC Section 1202, you should explore the benefits of a C Corporation as compared to an S Corporation. If the rules of IRC Section 1202 are met, the gain on sale may be excluded from tax for Federal income tax purposes. Discussion about IRC Section 1202 benefits is beyond the scope of this article.
Protecting S Status
An S Corporation can inadvertently lose its S status if you or other shareholders transfer stock to an ineligible shareholder such as another corporation, a partnership or a nonresident alien. If the S election was terminated, the corporation would become a taxable C Corporation. This would create a double tax structure and make it impractical to give a buyer a step-up in basis at exit. In order to protect against this risk, it is recommended for each shareholder to sign an agreement promising not to make any transfers that would jeopardize the S election. Once the S status is lost, it cannot be re-elected for another five years.
The S Corporation election can also become invalidated by disproportionate distributions that are intended to circumvent the second class of stock restriction. Care must be exercised to make distributions that are in proportion to stock ownership. Also, related party transactions should be carefully reviewed to avoid reclassification as distribution.
The following state considerations/formalities should be considered when determining whether an S Corporation is right for your business:
- While an S-Corporation does not pay federal income taxes, not all states follow this treatment. For example, the California annual tax for S Corporations is the greater of 1.5% of the corporation's California sourced net income or $800;
- For shareholders of community property states, where assets earned/acquired during a marriage are considered to belong to both spouses equally, having the signature of both spouses on the original S election Form 2553 is required for a valid election. If you already formed an S Corporation, but did include the necessary spousal signatures on Form 2553, we can assist in obtaining relief from the IRS; and
- Not all jurisdictions recognize the federal S Corporation election and/or may require a separate election be filed directly with the state (e.g., Arkansas, New York, etc.).
It’s worth noting that another option for a business with multiple partners is an LLC taxed as a partnership. In this article, we do not address the detriments of selecting an S corporation as opposed to an LLC taxed as a partnership. Before finalizing your choice of entity, consult with our team. We can answer any questions you have and assist in launching your new venture.