Choosing a Business Entity: S-Corporation

This is an excerpt from a presentation I give to college students and to prospective entrepreneurs about types of business entities.

A college professor (who’s also an attorney) told me that my presentation on this subject is the best, clearest and most-concise overview of the topic that she’s ever seen.

I’m flattered by the compliment, and will try to translate those positives into a series of blog posts.

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S-corporations share many of the same characteristics of partnerships. The biggest difference is, owners who work in the business day-to-day are paid a salary. (Tax law says this is a requirement.)

This salary is subject to FICA taxes and is deductible by the corporation. Any remaining income passes through to the owners and is subject to income taxation but NOT to self-employment or FICA taxes.

Example

Joe the Window Washer runs his business as a sole proprietorship. His net income is $100,000. Joe will pay both income tax and self-employment tax on $100,000.

If Joe is an S-Corp, he could:

1.Pay himself a reasonable salary (say, $60,000). The salary is subject to income tax and FICA taxes.

2.Joe reports the remaining $40,000 as income subject to income tax but NOT to FICA or self-employment tax.

Advantages of S-corporations

• Self-employment tax savings
• If the corporation suffers a loss, the loss passes through to the owner(s) to take as a deduction on their personal tax returns.

Disadvantages of S-corporations

S-corps rightfully get a lot of love, but they have a surprising number of pitfalls to be aware of.

• Reasonable salary issues. Business owners who work in the business MUST take a salary. It is tempting to play games with this, but this is something the IRS does audit.
• Compliance costs. Incorporating, filing corporate tax returns, complying with corporate formalities, etc. all take time and cost money.
• Net income is taxed to shareholders whether or not it is distributed. (Same concept as with sole proprietors and partnerships.)
• Unlike a partnership, special allocations are not allowed. For example, if two people own an S-corp as 50/50 owners, everything must be split 50/50. In a partnership, the partners could agree to split things in whatever ratio they see fit.
• Can only have up to 100 shareholders. Not a big deal for most small businesses, but this could be relevant for some people thinking about forming an S-corp.
• Limits on who can be a shareholder. Generall only individuals (NOT other entities), and only US citizens, can be shareholders. Again, perhaps not a big deal in most situations, but it could be.
• Only one class of stock is allowed.
• There can be issues with having real estate inside an S-corp. In simple terms: pulling real estate out of an S-corp is not as simple or tax-friendly as it is with a partnership.

In the next section, we’ll address the first item on this list in more detail — making sure the owner takes a reasonable salary.