C-Corporation, Limited Liability Company, Limited Partnership, Limited Liability Partnership, For Benefit Corporation….when forming a business and choosing the proper entity, the choices can at times be overwhelming. Each form has its own benefits and drawbacks (see our previous blog on entity forms), and the decision requires careful consideration as the consequences for your business are significant.
S-Corporations Status is a Federal Tax Election…NOT an Entity Form
However, let me dispel one of the most pervasive misunderstandings I hear when speaking with small business owners – the S-Corporation is NOT a business entity form. Rather, becoming an S-Corporation is a federal tax election (not without strings attached), whereby an otherwise existing entity can opt out of default tax classification by filing form 2553 with the IRS.
How Does it Affect You?
So…why should you do it? Or not? Generally, S-Corporations elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes, with the twist that owner-employees can pay themselves a “reasonable compensation” (see IRS Guidance here) and avoid paying self-employment taxes (funding social security and Medicare) on profits, guaranteed payments or other distributions above and beyond that amount. This could amount to significant short-term tax savings as the current self-employment tax rate is 15.3%.
So…Is It a No Brainer?
You might think that S-Corporation election is a no-brainer, however, this tax benefit doesn’t come without strings attached.
Qualification: First, only certain businesses are eligible for S-Corporation status. To qualify for S corporation status, the corporation must meet the following requirements (see here for more details):
Be a domestic corporation
Have only allowable shareholders
May be individuals, certain trusts, and estates and
May not be partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Minimum Duration: Additionally, S-Corporation tax election is a minimum 5-year election. So if you are planning to raise external capital, restructure your business, take on foreign partners, pursue an public offering or otherwise dramatically expand your business in the 5-years following S-Corporation election, you should think twice.
So What Now??
The bottom line is that qualifying small businesses of any entity form should strongly consider making an S-Corporation election, but not blindly and not without an eye towards future plans. Good accountants should be able to help you make this decision, or consult your corporate counsel (or e-mail us at [email protected]) to help you make this decision. And beware…if your attorney or accountant doesn’t know the distinction between general entity forms and S-Corporation status, you might want to shop around.
That’s all for now.