What is an S corp and is it right for me?

S corporations have tax advantages that make them a good choice for many small businesses. An S corp is a tax designation that allows a company's profits to pass through to the owners' personal tax returns. Both corporations and limited liability companies (LLCs) can choose to be taxed as an S corp.

But there are also some disadvantages, and not every business is eligible to be an S corp. Read on to figure out if it's right for you.

Business structure vs. business taxation

When thinking about S corp advantages, it's helpful to understand the difference between a business entity and its tax status. Before you can be an S corp, you must form a corporation or an LLC by filing paperwork with the state.

Your new business entity will, by default, be taxed in a certain way. Corporations are taxed as C corporations, which means they file a corporate tax return and pay corporate tax. Shareholders who receive profit distributions are also taxed on those profits. This is sometimes referred to as "double taxation."

LLCs are automatically taxed in the same way as sole proprietorships and partnerships. Owners report company profits as self-employment income on their personal tax returns.

But either a corporation or an LLC can change the way the business is treated for tax purposes by electing S corp taxation.

What is an S corp?

Unlike C corporations, S corporations. don't pay corporate income tax. Instead, profits pass directly to owners' personal tax returns. The owners then pay personal income tax on their share of the profits. In this way, S corporations avoid the double taxation of C corporations.

To be an S corp, your business must:

• Have no more than 100 shareholders
• Not have non-resident alien shareholders
• Not have owners that are corporations or partnerships
• Have only one class of stock

Electing S corp. taxation involves filing Form 2553 with the Internal Revenue Service (IRS). You must file the form within IRS deadlines.

Advantages of an S corp for LLC owners

When an LLC is taxed as a sole proprietorship or partnership, the owners are considered self-employed. Owners will pay Social Security and Medicare taxes (known as self-employment taxes) on their full share of the company's profits.

If your business earns significant profits, you may save on self-employment taxes by choosing S corp taxation instead.

S corp owners who work in the business can be company employees, and they must pay themselves a reasonable salary for the work they do. Like all employees, they'll pay Social Security and Medicare taxes on that salary, but additional company profits won't be subject to these taxes.

Owner-employees can also participate in company benefit programs, including 401K and profit-sharing plans. However, some employee benefits like medical and life insurance can be taxable if an employee owns more than two percent of the company.

The main S corp. disadvantage for an LLC is the required paperwork and fees. You must elect S corp. status with the IRS, you'll have to run payroll and withhold taxes, and you may also be subject to greater IRS scrutiny over whether you're paying yourself a fair and reasonable salary.

For a small business with few profits, the disadvantages of an S corp can outweigh the advantages.

C corp vs. S corp tax advantages

While large companies are typically C corporations, small business owners often prefer S corp taxation because their profits aren't taxed at both the corporate and shareholder levels. But there are S corp tax disadvantages for some businesses.

A company might benefit from C corp taxation if:

• It's a startup hoping to attract outside investment. Institutional investors usually prefer C corporations.
• It plans to keep money in the business to fund future growth. C corp shareholders only pay tax on money distributed to them, whereas S corp owners pay tax on all company profits.
• It doesn't meet the requirements for S corp taxation.

The tax advantages of an S corp depend on several factors, including the size and profitability of your business, whether your business is organized as a corporation or an LLC, and your business and personal goals.

It's best to review S corp advantages and disadvantages with a tax professional who can help you think through the issues and make the choice that's best for you and your company.

S corporations have tax advantages that make them a good choice for many small businesses. An S corp is a tax designation that allows a company's profits to pass through to the owners' personal tax returns. Both corporations and limited liability companies (LLCs) can choose to be taxed as an S corp.