Forming an S Corp has become an extremely hot topic in today’s financial world. In a lot of ways, forming an S Corp can be a great business decision, but there can be some disadvantages that need to be considered.
What is an S Corp?
When I talk about forming an S Corp, I don’t actually mean forming a separate business. S Corporations are not a business type like you would consider a corporation, an LLC, a partnership, or a sole proprietorship. S Corps are an elected tax status with the federal government.
There are a few requirements that have to be met in order to form an S Corporation, but the main three are:
- No more than 100 shareholders (married couples can elect to count as one person)
- Only 1 class of stock
- No foreign or corporate investors
These requirements aren’t super difficult to meet if your business is an LLC electing to be taxed as an S Corp, but sometimes, this can get tricky if a corporation is trying to elect S corporation status.
S Corp Considerations
When thinking about forming an S Corp, you need to consider how it will impact your business in the future. To do this, you need to ask yourself these seven questions.
1. Do you want to take a stable salary out of your business?
If that’s something that’s important to you, then forming an S Corp could be a good idea in the right situation.
It is the only business tax filing status that allows you to actually become both a shareholder and an employee after all. You can be guaranteed a salary on a weekly or monthly basis and also be able to take money out as shareholder distributions at different times.
2. Do I keep good financial records, and/or can I hire someone to do this for me?
In order to form an S Corp, you really need to have your ducks in a row so to speak.
Your financials should be clean, and you should be knowledgeable about their meaning because when your business tax status changes to an S Corp, suddenly the accounting treatment of many different transactions will change.
If your books are a mess, then this transition will be absolute chaos for you and everyone involved.
3. How has my business been performing?
Did you do amazingly well last year, and this year things don’t look so good? Maybe you’re making half as much income, or maybe your business is starting to stagnate?
If your business is not on a growth path or there’s any concern as to whether it will be able to keep going, then it may not be the right time to form an S Corp.
4. Is the business making a decent amount of net income?
Forming an S Corp can be a bit costly. There are added requirements for taxes, greater complexities with transactions and additional payroll costs. These costs can add up quickly and may outweigh the tax savings if your net income is too low.
I usually like to recommend conservatively that your business needs to be making at least $50,000 in net income a year to even want to consider forming an S Corp. An amount lower than $50,000 may also be advantageous, but it’s important to get an estimate of your savings versus your costs before making that decision.
5. Do you have any assets in the company right now or expect to in the future?
Assets can be tricky with S Corps. Cash and vehicles are not a problem, but when dealing with real estate and appreciating assets, there may be cause for concern. This is because the transfers of assets out of an S Corp are at fair market value.
This means that you might unknowingly trigger a taxable gain if you take this type of asset out of the company. If you didn’t receive any cash, then you may not be able to pay the tax.
6. Do you have any concerns about your number of shareholders or not having foreign or corporate investors?
If, by chance, you exceed 100 shareholders, or you have a foreign or corporate investor come on, you will essentially forfeit your S Corp status.
In this situation, the IRS could decide to revoke not only your current year status but also the last three years, requiring you to amend all of your prior tax filings. You would almost certainly owe more in taxes and penalties.
The IRS could also then impose a five year waiting period for you to be able to re-elect S Corp status. This is definitely the worst case, but it does happen.
7. Do you want to save money on taxes?
This is by far the biggest advantage of forming an S Corp.
As an S Corporation shareholder, you will wear two hats: employee and shareholder. Because you wear two hats, you can get money from the business in two separate ways.
As an employee, you are like any other employee. You will receive a paycheck periodically. That paycheck will have federal income taxes, Social Security, and Medicare withheld from it, and then you will get the net amount of wages in your paycheck.
As a shareholder, you can take additional cash out of the business in the form of distributions. These distributions can be taken out from either money or assets you contributed to the business or from current or former profits of the business. This is your distributive share, and it’s based on your ownership percentage in the S Corp. (Note: Distributions must be made to all shareholders at the same time based on ownership percentages.)
The beauty of this distributive share is that it is only taxed for federal income tax purposes. You will not pay self-employment taxes (Social Security and Medicare) on this amount. This leads to significant tax savings for many small business owners.
So, should you form an S Corp?
It all depends on your specific business situation. For some business owners, this makes a lot of sense. For others, there may be some big concerns. In most cases, though, it’s an income number. Is your net income high enough to outweigh the disadvantages?
There’s a lot to think about between setting yourself up on payroll, making sure you have an adequate salary, determining when you want to be paid, determining how distributions will work, getting help with the increased tax requirements and making sure your books are clean and up-to-date.
If you ever do decide that you want to become an S Corporation, the timing is also pretty important. There are some very specific rules about when you actually have to file for S Corp status so it’s important to contact a tax or accounting professional to really dig into the process.
To learn more about making an S election, check out the blog post here.
Note: This blog post is meant for educational and informational purposes only. Please contact a tax or accounting professional if you have specific questions about what this means for your business before taking any further action. Also note that these questions are not exhaustive.
