S-Corporation Advantages & Disadvantages: The Complete And Practical Guide To S Corporation
Running a business wearing many hats and needing to think about tax can be overwhelming. There is a lot of confusing information on the internet and social media about S corporations.
So, in this post, we will help you with a better understanding of S corporations.
What Is an S-Corp?
An S-Corporation is a small business corporation. The S corporation is not the terms determined by your state but an election with the IRS to allow your small business to be taxed at the shareholder level.
For example, you have a single-member LLC. When you select S corporation, your business will not be taxed at the business level, but it becomes the pass-through entity and taxed as your personal tax return – form 1040.
Advantages of an S Corporation:
- S corporation is considered a pass-through. This means you select to get the profit, loss, and credit of your business to be taxed at your personal return level. This is in contrast with C corporations – C corporations pay tax at the business corporation level, and any distribution to shareholders also needs to pay tax on that.
- Unlike a C corporation, an S corporation helps you avoid double income tax.
- You will not need to pay a self-employment tax on the whole net profit like a single-member LLC or sole proprietor. This is where you can save a lot of tax.
Disadvantages of an S Corporation
- You need to file an Article of Incorporation with your state, because without being an LLC or a C Corporation, you cannot select an S corporation.
- Many states, such as California, and New York.. have a franchise tax fee.
- You need to file an S corporation election with the IRS.
- You need to have reasonable compensation to the owners, such as yourself. If the compensation is not reasonable, you easily get scrutinized by the IRS.
- The shareholders need to be US residents or citizens. You cannot have foreigners as shareholders.
- If you plan to have your business become a public company or raise funds through investors
funding, an S corporation is not a great option because it has limits of 100 members as the shareholders, and also the equity part of it will not fit the best for raising funding.
How much will you save as an S Corporation?
This depends a lot on your net profit from the business and the reasonable compensation for yourself as the business owner. This is where you can issue w-2 for yourself.
15.3% is the self-employment tax including social security and medicare tax. This will be applied to the net profit of a sole proprietor or a single-member LLC. You only pay this rate for the w-2 compensation for yourself.
For example:
Your business made a net profit of $100,000 for the year.
- As a single-member LLC, you will pay $ 15,300 for the self-employment tax beside the federal income tax.
- Suppose you select an S corp and pay yourself a reasonable salary of $50,000. Your self-employment tax will be $3,825.
- The net profit of $50,000 left will pay tax at a capital gain rate of 5% or 7%, depending on the tax bracket. This can be $3500. So total tax $10,882.25 beside the federal income tax.
- So you save: $4,417.75 in tax
What is reasonable compensation?
In simple words, reasonable compensation is the salary you will pay someone to work in the similar work that you do for your business. This data can be based on:
- Your area.
- The census of the department labor
- Compensation of comparable positions.
- Size and the complex of the works.
There are more to consider, but you can always contact us and we can help you more with the calculation.
When Should your Business Become an S-corporation?
Most of the time, you will need to register with the state for a LLC or a Corporation before the S corporation selection. This election will be beneficial when you make profit above at least $50,000.
How Do I Apply for S-Corp Status?
Here are steps to apply for an S corporation:
- Choose your business name. You can search your state website and see whether the name is available or not.
- File the Article of Incorporation
- Issue stock certification for the shareholders.
- Apply the employer identification number (EIN) with the IRS.
- Depending on your state and what type of the entity you incorporate with your state, you may need to file additional documents. File the form 2553 to select an S corporation with the IRS within 75 days of your incorporation.
If you need help to form an S corporation, we can help you.
We have worked with many small business owners across the country and we would love to assist you as well. Please contact us.
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