Are You Planning To Incorporate a Business! Why Not an S-Corporation?

When you are planning to start a company, one of the key considerations you will have to make is what type of business entity to form. There are so many options:

  • Corporation
  • LLC
  • Partnership
  • LP
  • LLP, etc.

Then, within corporations there are different types as well:

  • C corp
  • S corp

Plus, each entity type comes with further differences from state to state. It can be overwhelming to wrap your head around it all. Many people are especially confused about the difference between a C corporation and S corporation.

An S corporation is a regular corporation that lets you enjoy the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner.

Unlike a C-Corp, which is a more conventional type of corporation, an S-Corp is a “pass-through” entity, meaning that it does not pay any income taxes on the corporate level. Instead, it passes the income tax responsibility on to employees and shareholders who receive their income through the company.

In an S-Corp, however, the IRS requires owner-operators who have direct control over operations to allocate a reasonable salary to themselves instead of relying completely upon income through corporate ownership. As with other pass-through business owners, S-corporation owners face the similar marginal tax rates as individual wages earners. However, how much owners pay in taxes can differ based on how much they participate in the business. These businesses are only allowed to have 100 shareholders, their shareholders must be U.S. citizens.

All owners of S-corporations need to pay federal individual income taxes (top marginal rate of 39.6), state and local income taxes (from 0 percent to 13.3 percent).

No Self-Employment Tax for S-Corporation shareholders business’s profits

The big benefit of S- corp taxation is that S-corporation shareholders do not have to pay self-employment tax on their share of the business’s profits.

The big catch is that before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary).

This salary will of course be subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

Restrictions on S Corporations

There are a few key restrictions on S corporations as well.

For one, an S corporation may not have more than 100 shareholders, and all shareholders must be US citizens or US residents. There are no such shareholder restrictions for a C corporation.

Furthermore, C corporations are allowed to divide up voting rights by issuing different classes of stock.

S corporations are limited to one class of stock, giving all shareholders equal voting rights.

Finally, some types of businesses are not permitted to become S corporations. These include banks and some insurance companies, among other business types. C corporations are usually a better choice for large businesses with their sites set on an IPO due to their greater flexibility because an S corporation is restricted to not more than 100 shareholders.

Other Taxes

While paying yourself as an owner rather than as an employee reduces the employment taxes you must pay, income that you receive as the business owner is still subject to other taxes. As partial owners of an S-Corp, shareholders must report any income they receive on the IRS 1040 form K1, which makes this income subject to dividend or capital gains taxation.