In this four-part series, we examine the different ways to structure your small business, comparing the various advantages and disadvantages of each

 

Part III - S Corporation

 


By Reed Richardson

 


The notion of a forming an incorporated business that would also enjoy many of the same pass-through tax advantages as a sole proprietorship or general partnership was what prompted the IRS to first create S corporations more than 50 years ago. At the time, S corporations were a fairly effective way for small business owners to hedge against liability while still retaining more control over their companies and profits. However, the popularity of S corporations has waned noticeably in recent years. "Limited liability companies have largely replaced S corporations," noted tax attorney and author Anthony Mancuso, in his book LLC or Corporation? "The LLC provides substantially the same benefits as an S corporation without several of the significant restrictions of S corporations." What are those restrictions and how do the two business structures compare? We weigh these in our point-by-point discussion below:

Operations - Both the S corporation and the more traditional C corporation (for more on C corporations see Part IV in this series) are established using the same procedures. First, the new company must establish a corporate charter naming its shareholders. Only then can the new corporation elect to convert itself to an S corporation through a filing of Form 2553 (http://irs.gov/pub/irs-pdf/f2553.pdf) to the IRS. Similarly, S corporations must abide by all the normal rules of corporate governance involving the issuance of stock, election of company officers, holding of regular (at the minimum, annual) meetings of a board of directors, keeping of minutes of these meetings, and following any other rules established by your state's corporation code. While many of these amount to little more than a formality for a very small business, they do add to the administrative burden of the small business owner. LLCs, by contrast, are largely free of these administrative hassles.

Tax - What is most important to understand about S corporations is that there is really no difference between them and a regular C corporation in legal terms. The major difference between the two business structures involves how they are taxed under federal law. (The "S" actually stands for "subchapter S," which is the applicable part of the U.S. Tax Code that covers S corporations.) As with a sole proprietorship, general partnership, LLC, or LLP, S corporation profits can pass through to the shareholders and be reported on their individual tax returns, making for a much easier filing process come tax time. And while an S corporation pays no federal corporate taxes, one must still file a corporate return (Form 1120S) for informational purposes only. However, keep in mind that some states still require payment on S corporation profits in addition to taxing the passed-through profits on a shareholder's individual return-in effect, taxing those gains twice-so it's imperative to check with your state's tax division and weigh the impact before electing to go the S corporation route. Again, LLCs and LLPs typically avoid this potential for an additional tax burden, although some states do require LLCs to pay a roughly equivalent "franchise tax" in addition to the individual income taxes paid on company profits.

 

One other somewhat arcane, yet important, point related to taxes: Shareholder debt in an S corporation cannot be passed through unless each member has personally guaranteed it. As a result, a shareholder's tax basis in an S corporation does not increase when the company borrows money. LLCs, on the other hand, allow shareholders to enjoy the tax benefits of this business debt whether or not they've personally guaranteed it, making it less likely that they'll be taxed on the business's profits in the long term.

Personal liability - Per the rules of incorporation, an S corporation automatically provides shareholders personal liability from risks-operational or financial-incurred by the business. However, LLCs effectively do the same thing without the requisite corporate rules and restrictions.

Raising capital/adding partners - Unlike a standard C corporation, S corporations are limited to a maximum of 100 shareholders, can only issue one class of stock, and only U.S. citizens or residents may participate. LLCs, on the other hand, let pretty much anyone or anything-U.S. citizen, foreign citizen, another LLC, or corporation-become a member. For most entrepreneurs, the 100-shareholder limit isn't much of an operational constraint, but it is an important consideration if your start-up business is expected to grow rapidly or seek out large sources of outside capital. In that case, the inability to create large private or public stock offerings or issue preferred shares could be a potential drawback. Note, though, that the federal tax code does allow a husband and wife to treat their joint stock holdings as those of a single shareholder.

Be sure to come back for Part IV in our business organization series, which deals with the pros and cons of the C-Corp structure.

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