Deciding which type of business entity is best for your business is not an easy decision. The corporate entity you select can have a huge impact on business taxes. The Internal Revenue Service recognizes C corporations and S corporations for federal income tax purposes. An S corporation allows a business to avoid double taxation because it is not required to pay corporate income tax on the company’s profits. Read on to learn more about the benefits of S Corp election for corporation.
S Corporate Status Overview
There are many benefits of S corp election when setting up a new corporate entity. In essence, an S corporation, also referred to as an S Corp, is a special corporation created through an IRS tax election. In this case, an S Corp holds a Subchapter 5 designation from the IRS. The S corp election and designation allows profits and losses to pass through to the shareholder’s personal tax return. Basically, the business itself is not taxed and shareholders are required to pay themselves reasonable compensation.
The Benefits of S Corp Election
- Double Taxation is Eliminated
As mentioned above, a key benefit of an S Corp election is that profits and losses are passed through to shareholders. Accordingly, taxes are only paid once. For example, business income, as well as most tax deductions, are passed through to the owners instead of being taxed at the corporate level. This avoids “double taxation.”
- Salary and Dividend Payments
An S Corp owner can choose to receive both a salary and dividend payments. Essentially, this can result in a lower tax bill because dividends may not be subject to employment tax.
- Liability Protection
S Corp election allows protection of the shareholder’s personal assets. For example, the shareholder’s personal assets remain separate from the business’s assets and are therefore protected in the event a judgment is asserted against the business. In this regard, company directors, officers, shareholders, and employees personal assets are protected under an S Corp and shielded from the claims of business creditors.
- Simplified Accounting Rules
An S Corp election allows for easier accounting rules. As an illustration, S Corps without any inventory can use the cash method of accounting. This method is simpler than the accrual method.
The Disadvantages of S Corp Election
- Strict Formation Requirements
There are strict requirements that must be met in order to when a corporation makes an S Corp election. For example, individuals, certain estates and trusts, and tax exempt organizations can form an S Corp. Furthermore, only U.S. citizens and permanent residents can form an S Corp. Additionally, an S Corp can have no more than 100 shareholders. Lastly, there can only be one class of stock.
- Corporate Formations
An S Corp is required to comply with corporate formalities. The IRS heavily scrutinizes S corporations. For this reason, it is important to establish a reasonable amount of salaried income to avoid tax penalties. In California, S corps must pay an annual tax, with a minimum being $800.
In order to form an S Corp, you must first create a regular corporation by filing articles of incorporation with California’s Secretary of State. Next, all shareholders must sign and file IRS Form 2553. Form 2553 must be filed 1) no more than two months and 15 days after the beginning of the tax year the election is to take effect, or 2) at any time during the tax year preceding the tax year it is to take effect.
Contact A People’s Choice for more information about about how to make an S Corp election for your corporation. We can help you draft and file all the documents you need to set up your corporation with the California Secretary of State and to apply for S Corp status.