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.
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.
Forming an S-corp brings significant benefits to a business owner.
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.”
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.
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.
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 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.
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.
There are many benefits to setting up an S-corp, but there are some disadvantages you should consider:
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.
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.
|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.