The S Corp Tax Consideration – aka The Soloprenuer
The S Corporation
The income in S corporation is not taxed to the corporation; instead, income is reported by the business shareholders within portions of their holdings without regard of their distribution amount. The distributions of company stockholders of tax paid income are not taxed again in the company stockholders level. Losses are also reported by the company stockholders in the portions of their stock holding. In summary, S corporations avoids the possibility of double taxation of distributed earnings, this is unlike in C Corporations that requires stockholders to report their shares of business’s losses.
On the other hand, requirements for qualifying S corporation significantly limit many business founders from utilizing this utility. For instance, S corporation has to be owned by entirely United States residents, estates, certain tax exempted organization, certain type of trust. None of the S corporation stockholder can be a non United States individual. In addition, Solo Corporation should only have one class of outstanding stock; the difference in voting right is allowed, but difference in rights to distribution is not permissible.
Qualification for S corporation status
- You have to be a domestic corporation
- It should have not more than one hundred shareholders
- Has to have single class of stock
- Not to be Ineligible Corporation like insurance company or certain financial institutions
- S corporation should have only allowable stockholders, e.g. certain trusts and estates, and US residents. Non resident stockholders and partnership corporations are not allowed.
For founders of new business, conducting a business through a legal entity is the right way to conduct business so as to limit their personal liabilities for obligations and debts the business generates. The three main business entities which founders must consider when starting any business include; the S Corporation, the C Corporation and the limited liability company Limited Liability Company.
While all the entities insulates the business founders from any personal liabilities, the difference among the three types in terms of tax purposes are significant. Therefore one has to be very keen when choosing Solo, S Corp & personal income tax considerations. A C Corporation reports & pays on its income separates from its founders. On the other hand, income or loss of a Limited Liability Company and S corporation is reported by the founder on their returns. Therefore, the choice on business entity is often tax driven and depends on how business founders or owners expect to profit and grow from their business.
Limitation of S Corporation
Not every business can be elected so as to be taxed as an S corporation. The business eligible for S Corporation have to have owned entirely by United States residents.
S corporation has to have maximum of one hundred or fewer business stockholders for it to be eligible with members of the same family being counted as one business stockholder. This can eases the impact of one hundred stockholders limit for a family owned corporation.
There can only be a single class of stock in the S corporation. While this is considered as a limiting factor, the fact that there can be voting and non voting shares eliminates many issues when the business is family owned. Since you can’t have one type of share receiving dividend while the other doesn’t, you can always transfer non voting share to member of your family.
In addition, trust holding has to meet certain requirements, though; these requirements often do not limit what can be done in small and mid sized businesses.
Factors that favor S corporation
Business owners must decide between C Corporation on hand, or Limited Liability Company and S Corporation on the other end. Once you have ruled out C Corporation, they then decide to choose between Limited Liability Company or S Corporation. The following are factors that favor S Corporation over Limited Liability Company.
- S corporation is more versatile compared to Limited Liability Company when it comes to exit strategy. Stockholders can avoid reporting their exit gain as ordinary income by simply structuring their exit gain as a stock sale as opposed to asset sale.
- Although, equity incentive arrangement for S corporation are more complicated compared to C Corporation, S corporation has a simpler equity incentive arrangements when compared to Limited Liability Company. Similar to C Corporation, the S corporation can grant ISO.
- Founder- employee of S corporation gets reasonable pay because only wage payment is subject to tax; income from S Corporation as stockholder is not taxed. A business founder employee of a Limited Liability Company, on the other hand, can be subjected self employment tax and entire share of Limited Liability Company’s income.
- S Corp can be eligible for local property tax exemption unlike Limited Liability Corporation. These exemptions are very important when the business has a significant amount of inventory, personal property and machinery.
What are impacts of Timing of S Corporation?
If you do not elect your business immediately to S corporation status, you will have to deal with built in gains from where the corporation was initial regular i.e. C Corporation. If you have been previously operating your business as a C corporation and decide to elect it to S corporation, make sure that you have worked with the accountant to address all potential tax issues that can arise from the election.
Also when converting your corporation from S Corporation to another business entity, it is a liquidation that can trigger recognition of built up appreciation corporation valuation, thus trigger recapture of pushed depreciation. All these situations have to be avoided through thoughtful tax plan by a trained professional.
When the S corporation is considered:
Business owners should consider S Corporation if they meet the requirements of this entity, want arrangement that will avoid double taxation and allows reporting of shares of any losses while retaining their ability to exchange their stocks for stocks of an acquirer on non taxable basis in reorganization, thus maintaining ability to motivate consultants and employees with traditional corporate equity incentives while minimizing the their employment taxes. When it comes between selecting S Corporation and Limited Company, S corporation is more preferable of the two.