As a shout-out to all my accountant readers and colleagues, I would like to discuss a corporate structure with an S Election – or the S-corporation structure. Many business owners choose to structure their companies as S-corporations. This status provides small businesses with many of the benefits of incorporation while affording them the flow-through taxation that comes with a partnership, or at least ninety-five percent (95%). While an S-corporation is specifically a tax designation, the structure also offers most of the liability protection and the management advantages of a C-corporation.
What is an S-Corp?
An S-corporation, also known as an S-corp, is nothing but a corporation organized under state law. The special “S” status is an election made at the federal and the state level to alter the taxation of the corporation and to be recognized by the Internal Revenue Service (IRS) for tax purposes. As the S-corp is a flow-through entity, shareholders report their income and losses on their individual tax returns for the most part. An S-corp is a separate legal entity from its owners, offering shareholders limited liability and asset protection.
How is an S-Corp Formed?
Certain criteria must be met to form an S-corp. First, the company must be a domestic corporation and have only allowable shareholders — including individuals, certain types of trusts, and other S-corps. In addition, an S-Corp must have no more than 100 shareholders and is limited to one class of stock.
To become an S-corp, Form 2553 “Election by a Small Business Corporation” must be signed by all shareholders and submitted to the IRS. The election must be made no more than two months and fifteen days following the beginning of the tax year that it is meant to take effect — or at any time during the tax year before the year it will take effect. Late elections may be permissible if the failure to timely file was due to a reasonable cause.
Once the S-corp election has been made, it remains effective until it is revoked or terminated.
What are the Pros and Cons of an S-Corp?
A business should weigh the pros and cons to determine whether an S-corp is the right selection for a specific company. While an S-corp is less flexible than a Limited Liability Company, they generally have a lower audit risk than a single-member Limited Liability Company which is reported on Schedule C and can substantially reduce self-employment taxes. Other advantages of forming an S-corp include the following:
- Pass-through taxation — S-corps do not pay federal taxes at the corporate level. Profits and losses pass through to shareholders and are reported on their personal income tax returns.
- Favorable characterization of income — Shareholders of an S-corp should draw reasonable salaries as employees of the corporation and receive dividends as well as other tax-free distributions.
- Asset protection — Creditors are unable to go after the personal assets of shareholders of an S-corp unless the creditor was able to pierce the corporate veil of the corporation.
- Cash method of accounting — S-corps typically don’t have to utilize the accrual method of accounting unless inventory is involved.
- Easy transfers of ownership — Interests in an S-corp can be transferred without incurring negative tax consequences so long as the S-corp permits the transfer and the transfer is to a permitted person.
Critically, an S-corp can also have some disadvantages. Stock ownership restrictions and less flexibility in income and loss allocation are a few potential drawbacks. S-corp status is not recognized in New York City, thus subjecting a business to double taxation and the city’s general corporation tax even if Form 2553 has been submitted to the IRS. Businesses that are federal S-corporations may make S-corp elections at the state level with the consent of the company’s shareholders.
Contact a Knowledgeable New York Business Formation Attorney
The structure you choose for your business can have long-term legal and financial ramifications. It’s essential to have a skilled business attorney who can guide you through the formation process and assist you with choosing an entity type that meets your goals. Brinen & Associates provides knowledgeable counsel for a wide variety of business matters, including strategic entity formation. Call (212) 330-8151 or send us a message to schedule a consultation.