6 Benefits of Forming an S Corporation

What is an S corporation? 

An S corporation, often called an S corp, is a specific corporation type that draws its designation from Subchapter S of the tax code. To start an S corp, a small business owner would start a C corporation (or C corp) in the state where it’s headquartered and then file 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 corporation — or any other type of corporation — can be intimidating. However, it’s a crucial move that can protect your personal assets, provide tax breaks, and give your business the legitimacy it deserves. 

Benefits of forming an S corp

Forming an S corp brings significant benefits to a business owner. Consider the following advantages:

1. 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 double taxation that affects C corporations. 

Because 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. 

However, there is an important caveat related to compensation management: Any shareholder who works for the company must pay themselves reasonable compensation. This means the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as wages.

2. 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.

3. An S corp allows you to avoid self-employment taxes.

The owners of an S corporation are considered employees, not owners, of the company. As an employee, you are not subject to self-employment taxes that members of an LLC would have to pay.

4. An S corp reduces your taxable gains.

If you plan to sell your business 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.

5. An S corp has a life of its own.

An S corp is an excellent option if you plan to build a lasting business rather than a side hustle that 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.

6. It’s easy to change S corp ownership.

Let’s say you have the best intentions to run your business and stick with it — 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 of setting up an S corp, but you should be aware of these disadvantages: 

• S corps may incur fees. Depending on your state, you may have ongoing fees and expenses related to your S corporation. These fees aren’t usually high, but they’re a cost you won’t incur as a sole proprietor.
• S corps have the potential for costly mistakes. If you make any mistakes regarding stock ownership, consent or notification to the IRS, it could cost you your S corp status.
• S corps have strict requirements. Compared with other types of incorporation, an S corp has a strict management structure. You must appoint a board of directors and officers and hold annual shareholder meetings.
• S corps have potential tax liabilities. The IRS requires S corp owners to pay themselves a reasonable salary for the services they provide to the company. If you make your salary too low to save on the self-employment tax, this will raise red flags with the IRS. 

Other business structures to consider

If you’re on the fence about setting up an S corp, there are other options to consider. Here’s a breakdown:

Here’s more information about these business structures: 

• C corporation: A C corp is similar to an S corp in that you’ll receive certain tax benefits. However, unlike an S corp, a C corp can have unlimited shareholders, including 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 must 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 and 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; there is no legal separation. Sometimes, people who freelance or have a side gig operate as sole proprietors because they don’t have to do anything to establish one. However, you can be held personally liable for any lawsuits or debts incurred by the business.