Whether you are just starting your business, or have been operating as a sole proprietor or general partner, you may be wondering about the advantages of incorporating your business as an S corporation.
Many business owners assume it will be too costly or time-consuming—but neither is the case.
What is an S corporation?
The definition of an S corporation is a corporation that is treated, for federal tax purposes, as a pass-through entity through an election made with the Internal Revenue Service (IRS) to be considered an S corporation. S corporations are taxed nder Subchapter S of the Internal Revenue Code (IRC), which is where their name is derived from (Subchapter S Corporation). What does that mean?
As a corporation, an S corporation is created through filing Articles of Incorporation with the Secretary of State or similar government body. It issues stock and is governed as a corporation, with directors, officers, and shareholders who function in the same manner as their C corporation counterparts. The owners (the shareholders) have the same protection from liability as shareholders of a C corporation. An S corporation shareholder’s personal assets, such as personal bank accounts, cannot be seized to satisfy business liabilities.
However, like a sole proprietorship or a partnership, an S corporation passes through most of its income and loss items to the shareholders. Unlike a regular corporation, there is no "double taxation," meaning that the owners do not need to pay taxes twice - once at the corporate level and again on the individual shareholder level. Each shareholder is subject to his or her own individual tax rate on the profits and losses passed through to him or her, recorded as net income on the income tax return.
S corporation advantages
The advantages of an S corporation often outweigh any perceived disadvantages. The S corporation structure can be especially beneficial when it comes time to transfer ownership or discontinue the business. These advantages are typically unavailable to sole proprietorships and general partnerships. S corporation advantages include:
- Protected assets. An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder does not have personal liability for the business debts and liabilities of the corporation. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same—leaving personal assets vulnerable.
- Pass-through taxation. An S corporation does not pay federal taxes at the corporate level. (Most—but not all—states follow the federal rules. View the Ongoing Corporation Requirements page of our state guides to see if your state recognizes the federal S corporation election.) Any business income or loss is "passed through" to shareholders who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns to reduce income tax paid. This can be extremely helpful in the startup phase of a new business. (A corporation that does not elect S corporation status and accumulates passive income is at risk of being classified as a personal holding company.)
- Tax-favorable characterization of income. S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.
- Straightforward transfer of ownership. Interests in an S corporation can be freely transferred without triggering adverse tax consequences. (In a partnership or an LLC, the transfer of more than a 50-percent interest can trigger the termination of the entity.) The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.
- Cash method of accounting. Corporations must use the accrual method of accounting unless they are considered to be small corporations. (A small corporation has gross receipts of $5,000,000 or less.) S corporations, however, usually don't have to use the accrual method unless they have inventory.
- Heightened credibility. Operating as an S corporation may help a new business establish credibility with potential customers, employees, vendors and partners because they see the owners have made a formal commitment to their business.