Remember way back when as you started your business? Like most entrepreneurs, you probably chose to form a sole proprietorship because it’s less paperwork and less costly. But as your business grows you might benefit from the protections provided by a Limited Liability Company (LLC) or C-Corporation. But if you are currently a C-Corp, does it make sense to switch and choose to elect S-Corp status in light of tax benefits for pass through entities like the Section 199A 20% Deduction? If you have questions about the options and what the benefits are, here are some answers.
The C-Corporation
The biggest reason to form a C-Corp is strong protection from business liability for the business owners and/or shareholders. It can have an unlimited number of shareholders. The C Corp is legally a completely separate entity from the owners and shareholders, so it has no bearing on their personal assets. C-Corps can sell stock or shares, offer employees a stock option plan, and if you plan to go public one day, the company must be structured as a C-Corp.
Profits and losses are owned by the corporation only, and taxes are based on the corporation’s activity. Business expenses, retirement plan costs and employee benefits are tax deductible to the corporation. One of the drawbacks is that dividends to the shareholders are taxable as the shareholder’s income, so owners of the corporation pay taxes both on the corporation’s profits and on their dividends. Also, you pay several state and federal filing fees in addition to the various city licenses and industry certifications your business may need. The law requires a C-Corp to:
- Select a Board of Directors, meet with the board regularly and keep detailed meeting minutes.
- Formally register the business by filing Articles of Incorporation with the state.
- Obtain a Tax ID Number or Employee Identification Number (EIN) from the IRS.
- Draft corporate bylaws, the official rules for operating and managing the company, proposed and voted on by the Board.
The Limited Liability Company (LLC)
An alternative choice to the C-Corp is to form a Limited Liability Company (LLC). Although less stringent a business structure than the C-Corp, it still provides the owners protection from liability. The LLC is considered a separate legal entity from its members and is responsible for its own finances and legalities in the case of a lawsuit.
Additional benefits are that LLCs require less paperwork to set up. There’s no board of directors, so there’s more flexibility when making business decisions. The LLC’s members create and file Articles of Organization with the state and make the decisions. LLCs still need to acquire an EIN number and maintain the necessary licenses and permits.
Difference Between the C-Corp and the LLC
An LLC has a choice on how it wants to be taxed. Although the LLC protects its members from legal and financial liabilities, the LLC is not a separate entity in the eyes of the IRS. It is considered a “pass-through entity,” similar to a partnership or sole proprietorship. Profits and losses of the LLC are passed through to the members and must be claimed on their personal tax returns—unless members decide to have the company taxed as a C-Corp. In that case, profits are taxed at the corporate rate, a flat 21%.
The S-Corporation
There is another taxation option: electing S-Corp status. The S-Corp isn’t a legal business entity, but rather a special election made for tax purposes. The business still retains the liability protection of the C-Corp or LLC, but when S-Corp status is elected there is pass-through taxation and the business is no longer taxed at the corporate level.
What are the reasons a C-Corp or LLC would do an about face and elect S-Corp status?
The positive benefit comes from the income-splitting potential for owners of the LLC or C-Corp. Members or owners can decide to take a reduced salary, and then pay income taxes, Social Security and Medicare taxes on the smaller salary, and take the remainder of their compensation as dividends. Dividends are not subject to self-employment tax, so a dividend distribution is subject only to income tax.
Keep in mind, profits are passed through to the individuals, so the S-Corp is not necessarily beneficial to companies with high earnings. There are also limits on the number of shareholders an S-Corp can have, so if the business is soliciting investors it might not be the best choice. However, S-Corp losses can be written off on a taxpayer’s personal tax return, so for startups or other businesses with losses it may be beneficial. To qualify for S-Corp status:
- The business must be a U.S. corporation or LLC.
- It can maintain only one class of stock.
- It’s limited to 100 shareholders or less.
- Shareholders must be individuals, estates or certain qualified trusts.
- Each shareholder must consent in writing to the S Corporation election.
- Each shareholder must be a U.S. Citizen or permanent resident alien with a valid United States Social Security number.
- The business must have a tax year ending on December 31st.
Each business is unique, and often when there is more than one business owner, individual goals may vary. In general, a business should start off as an LLC because the structure is simple and flexible. Later, as the business grows and becomes more complex, S-Corporation status may make more sense depending on the circumstances. Instead of converting to a corporation and then electing “S” status, it is easier to check the box and elect to file your LLC as an S-Corporation. You can always convert back to an LLC at a later date. Check with your Fuoco Group professional about the best option for you and your business.
Due to the 199A deduction, “S” status may be the best choice since shareholder wages are considered in the calculation of the benefit, but guaranteed payments are not.
The deadline is March 15th to elect S-Corp status by filing Form 2553 with the IRS. If you miss the deadline, the business will continue to be taxed as a C-Corp or LLC for the current tax year, and the S-Corp will kick in the following year. An automatic six-month extension to file for S-Corp status can be obtained by filing IRS Form 7004.
CONTACT US: Always check with your Fuoco Group tax professionals before making any changes. If you believe your entity’s status is not as advantageous as you thought it would be, let discuss your options as soon as possible. Call toll free 855-534-2727.
