Leaving your 9-to-5 to start your own business is a big decision, but it’s only the first step on your journey. Once you become an entrepreneur, you’ll have tons of decisions to make. For instance, you’ll have to choose a location, implement a hiring process, and settle on traditional and digital marketing strategies.
Another decision you’ll have to make early on is whether or not to set up an S corporation. This article will explain what an S corporation is, the pros and cons of setting one up, and some alternatives to consider.
What is an S corporation?
Many entrepreneurs are intimidated by the thought of forming a corporation. However, this is an important step you should take for your business.
A corporation will protect your personal assets, provide tax breaks and give your business the legitimacy it deserves. As far as incorporation goes, you have a few options, but many entrepreneurs opt to set up an S corporation, or S-corp.
An S-corp is a special type of corporation that draws its designation from subsection S of the tax code. To start an S-corp, a small business owner starts a C corporation (or C-corp) in the state where it is headquartered and then files for S corporation status with the IRS.
While an S-corp is similar to a C corporation, differing income and self-employment tax regulations set the two apart.
Before setting up an S-corp, you’ll need to apply for an employer identification number. An EIN lets you hire employees, open a business bank account and pay small business taxes.
Benefits of forming an S-corp
Forming an S-corp brings significant benefits to a business owner.
An S-corp brings pass-through taxation.
Like an LLC, an S-corp does not pay taxes at the corporate level. Any income or losses are reported only on the business owner’s personal income taxes.
As a result, business owners avoid the issue of double taxation that affects C corporations. Since net losses are “passed through” as well, the individual shareholder may be able to reduce their tax liability by offsetting other income with any S-corp losses.
There is an important caveat, however: Any shareholder who works for the company must pay themself reasonable compensation. This means the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages.”
An S-corp offers liability protection.
According to the IRS, S-corps are “considered by law to be a unique entity, separate and apart from those who own it.” The owners of an S-corp have limited liability for the company’s actions. This means owners can’t be held responsible for the company’s actions or debts unless the business owners have signed a personal guarantee.
An S-corp allows you to avoid self-employment taxes.
The owners of an S-corp are considered employees of the company, not owners. So as an employee, you are not subject to self-employment taxes that members of an LLC would have to pay.
An S-corp reduces your taxable gains.
If you open your business intending to sell it in the future, an S-corp is attractive for yet another reason. When you sell the company, your taxable gains from the sale can be less than they would have been if you were selling a C corporation.
An S-corp has a life of its own.
An S-corp is an excellent option if you plan to build a business that will last, not just a side hustle you plan to sell in a few years. Unlike an LLC, an S-corp has an unlimited life span.
Your business will continue to exist even if you leave the company. In fact, the business can even continue operating without too much trouble.
It’s easy to change S-corp ownership.
Let’s say you have the best intentions to run your business and stick with it through the years. But life happens, and you are forced to transfer ownership.
With an S-corp, ownership is easily transferred through the sale of the company stock. And if you try running an S-corp for a while and decide it isn’t for you, you can easily drop this status with the IRS.
Downsides of an S-corp
There are many benefits to setting up an S-corp, but there are some disadvantages you should consider:
- Potential fees: Depending on your state, you may have ongoing fees and expenses. These fees aren’t usually expensive, but they’re a cost you won’t incur as a sole proprietor.
- Potential for costly mistakes: If you make any mistakes regarding stock ownership, consent or notifying the IRS, it could cost you your S-corp status.
- Strict requirements: Compared to other types of incorporation, an S-corp has a strict management structure. You must appoint a board of directors and officers and have annual shareholder meetings.
If you think an S-corp may be the right legal structure for your business, seek out the advice of an attorney, who can inform you of your options and recommend next steps based on your situation.
Other business structures to consider
If you’re on the fence about setting up an S-corp, there are other options to consider. Here are four alternatives to an S-corp.
- C corporation: A C-corp is similar to an S-corp in that you’ll receive certain tax benefits. But unlike an S-corp, a C-corp can have an unlimited number of shareholders, and the shareholders can be company employees. However, a C-corp can be hit with double taxation; this happens when the company’s profits are taxed on the corporate level and then again on an individual’s tax return.
- LLC: A limited liability company is a business entity that separates the business’s assets and the owner’s personal assets. To set up an LLC, you’ll have to file articles of incorporation with the state. However, an LLC is less expensive and less tedious to manage than an S-corp.
- Partnership: In a partnership, the members can structure the business as they see fit. All partners will have an equal share in the company as well as its profits and losses. You should form a partnership only with someone you trust.
- Sole proprietorship: In a sole proprietorship, the business and the individual are the same, and there is no legal separation. Sometimes people who freelance or have a side gig will operate as a sole proprietors because there’s nothing you have to do to establish one. However, you can be held personally liable for any lawsuits or debts incurred by the business.
If you plan to dissolve a partnership, you and your former business partner can both be sued during and after the dissolution process.
|Business structure||Ownership||Owner’s liability||Tax|
|S corporation||1+ people||Not held personally liable||Corporate tax|
|C corporation||1+ people||Not held personally liable||Corporate tax|
|LLC||1+ people||Not held personally liable||Self-employment tax|
|Partnership||2+ people||Held personally liable unless structured as a limited partnership||Self-employment tax|
|Sole proprietor||1 person||Held personally liable||Self-employment tax|
Deborah Sweeney contributed to the writing and research in this article.