S Corporations have been making major headlines in the news. The Tax Cuts and Jobs Act (TCJA) is a new tax reform law that gives pass-through entities, like S Corps, a 20 percent deduction for qualified business income. The changes take effect in January 2018, so it will not affect tax returns filed for 2017.
Since pass-through entities are being significantly affected by the new tax law, many entrepreneurs are mulling over whether or not they should stay an S Corporation. Those that aren’t incorporated as an S Corp may also be considering if they should make the switch. While I cannot provide tax advice or tell anyone exactly what is best for their business, what I can do is outline more about what an S Corporation is and the benefits that the entity offers a business.
What’s an S corporation?
An S Corporation begins as a C Corporation or an LLC, which makes it a C Corp with an S Corp tax election. While the entity tends to operate in the same manner that a corporation would, their S Corp election essentially tells the federal government that it would like to be taxed as a partnership and not as a corporation. This helps small businesses to get around double taxation at the corporate level.
S Corps elect to have their profits, losses, deductions, and credits “pass-through” the entity level and only have them taxed at the shareholder level. Only the wages of an S Corp shareholder, who is an employee of the business, are subject to employment tax. As such, shareholders must be paid what is commonly referred to as “reasonable compensation” to avoid having the IRS reclassify their corporate earnings as wages.
Tax benefits aside, S Corps provide shareholders with protection for their personal assets and allow businesses to gain credibility. However, filing as an S Corporation comes with its fair share of requirements. In order to qualify, you must be based out of the United States and filed as a U.S. corporation. Your business must comprise shareholders that are individuals, estates, or certain qualified trusts with a maximum of 100 shareholders and issuing only one class of stock.
How an S corp differs from a C corp
The biggest difference between an S Corp and a C Corp? Double taxation.
As I mentioned before, S Corps do not pay taxes at a corporate level, thanks to being taxed as a partnership. The structure of a C Corporation is much more traditional and is affected by double taxation, due to profits being taxed separately from the owners of the business.
Despite being more traditional, C Corps offer many benefits to entrepreneurs, including the ability to write off certain benefits as business expenses, raise investment capital and even go public.
What should you do next?
As I mentioned before, I cannot fully advise any entrepreneur whether they should stay incorporated as an S Corp or switch to another entity like a C Corp. Even conducting research can only add to the confusion if you aren’t familiar with the ins and outs of the new tax law.
The next best step would be to meet with a tax professional. By meeting with a tax professional, you will be able to discuss the TCJA in depth and determine which changes apply to your situation as well as the effect they will have in the long run. Start scheduling meetings now so you’re prepared when the time comes to file your 2018 tax returns – it’s never too early to start thinking ahead.