How you structure your company can have a big impact on many aspects, including your cash flow, how you will want to manage inventory, and your personal and business taxes. What is an S corporation, and how is it different from an LLC and a C corporation? Since we found a lot of confusion around the S-corp designation, we wanted to break down what it is and some important things to know about it.
What is An S-Corporation?
S corporations (or S-corps for short) are pass-through tax entities. They file federal returns (Form 1120S, but do not pay corporate taxes on income. Instead, the profits or losses of the corporation are passed through” to the shareholders, who can then claim on their tax returns. This means that business owners pay any tax due at the individual level.
What Are The Benefits Of Doing An S-corp?
Here are some reasons why an S corporation might be a great option for a business owner:
- S-corps provide limited liability protection for owners’ assets.
- Profits are taxed at a personal tax rate versus a corporate tax rate. This often means a lower tax rate and an ability to claim deductions, credits, and losses on personal filings.
- The overall tax bill can be reduced by the owner receiving a “reasonable” salary and then dividends for the rest of the profits (dividends are not subject to self-employment taxes).
What Are The Potential Drawbacks To Doing An S-Corp?
There are a few reasons why an S corporation might not be a good fit for a business owner:
- Strict qualifications around who can be a shareholder and how shares can be structured
- Profits must be allocated based solely on the percentage of ownership. There is no flexibility in the allocation.
- Corporate formalities such as having a board, conducting board meetings at least once a year, and keeping minutes at all board meetings
- Limited to 100 shareholders or less
How is An S-corp Different From An LLC?
Limited liability companies (LLCs) offer personal liability protection for the sole proprietor (single owner) or the partnership (two or more owners). LLCs protect the owners’ assets from losses, company debts, and court rulings against the company. While the S-corp is a federal tax designation, LLCs are a state-level identification.
Whereas S corporations are legally required to adopt by-laws and conduct annual meetings, LLCs are not legally required to do any management-investor events or have by-laws. LLCs can bypass the detailed requirements of corporate by-laws by merely adopting an LLC operating agreement. This operating agreement can be extremely flexible and, for the most part, allows the business owners to operate in whatever fashion they prefer.
Limited liability companies are taxed differently from corporations since they experience pass-through taxation. This means the business income or losses pass through the owner and are recorded on the owner’s tax return. The result is that business profits are taxed at the owner’s tax rate, and any profits, losses, or deductions, which are business expenses that reduce taxable income, are also reported on the owner’s tax return. One of the most important factors is taxing all net profits with an LLC. In contrast, with an S-corp, the business owner pays taxes on their salary, and then the remaining net income after deducting that salary can be issued as a non-taxed dividend.
How is An S-corp Different From a C-corp?
Traditional C corporations pay their taxes. Right, no, that means a flat 21% federal tax and a variable state tax based on your state. At the same time, any disbursements made out of a C-corp are usually in the form of salaries or dividends to shareholders. This is where C-corps get their reputation for double taxation – since the company is paying federal and state taxes. Then, the individual is charged payroll taxes, while the shareholder pays long-term capital gains taxes on any dividends received. This means that C-corps may be better for businesses that think they will quickly scale past 100 employees or want to show net profits and retain them within the companies.
While a C-corp pays corporate federal taxes, an S-corp usually does not pay federal taxes at the corporate level. As a result, an S corporation can help a business owner save money on corporate taxes. The S-corp allows the owner to report the taxes on their tax return, similar to an LLC or sole proprietorship.
How you structure your business will significantly impact your company finances. Depending on your model, growth, and time in the market, there can be significant tax benefits for converting your LLC to an S-corp. At Notion CFO & Advisors, we enjoy helping business owners find the right formation structure and tax strategy for their needs. If you have questions or want to discuss your business, call us at 913.901.6879 or contact us through our website.