As we approach a new fiscal year, it might be a good time to review the different types of business structures available and possibly revisit yours for tax efficiency and protections. Like most entrepreneurs, when you started your business you probably chose to form a sole proprietorship because it’s less paperwork and less costly. However as your business grows and becomes more complex, you might benefit from the protections as well the tax benefits provided by choosing to restructure as a Limited Liability Company (LLC), a C-Corporation, or an S-Corporation.
If your business is well established and currently a C-Corp, you might wonder if it make sense to switch and choose to elect S-Corp status in light of the tax benefits available for pass through entities like the Section 199A 20% Deduction!
What the C-Corporation Offers
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.
What the S-Corporation Offers
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. To qualify for S-Corp status, businesses must meet specific requirements set by the IRS. Some key characteristics of S corps include:
- Shareholder limitations- S corps cannot have shareholders that are partnerships, corporations or non-resident alien shareholders and cannot have more than 100 shareholders in total.
- Stock limitations- S corps may only have one class of stock.
- Pass-through taxation- Shareholders of S corps report their losses and incomes on their personal tax returns and are taxed at personal income tax rates. As a result, S corps can avoid the double taxation on corporate income that C corps experience.
What are the key differences?
C-corps and S-Corps are both potentially great options for businesses, depending on their circumstances and needs. The key similarity is the legal distinction between the shareholders’ personal assets and the corporation. Besides that, there are some notable differences.
- Business owners often elect to be a C-Corp if they find the following advantageous:
- Greater tax benefits. C-Corps offer better tax advantages due to an increased ability to deduct employee benefits. C-Corps may also provide tax savings if the corporation is not making income distributions to shareholders or the corporate tax rates are lower than personal rates.
- Unlimited number of shareholders.
- Self-employment tax savings. C-Corps can provide self-employment tax savings if owners are classified as employees.
- Additional ways to raise capital. Capital can be raised by selling stock.
- The ability to issue more than one class of stock. C-Corps can issue more than one class of stock, including tiered options.
On the other hand, business owners may find the following about S-corps more valuable:
- The ability to avoid double taxation: Since S-Corps are pass-through entities, S-Corp owners are not taxed at the corporate level. Taxes are only paid at the personal level by shareholders.
- Business income deductions: Due to Section 199A of the Tax Cuts and Jobs Act of 2017, eligible S-Corp shareholders can get a deduction of up to 20% of net qualified business income.
What are the reasons a C-Corp would switch 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.
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. If you choose to elect S-Corp status for 2025, the deadline is March 15th, which is two months and 15 days from the start of the tax year.
Reach out to us: While S Corporations and Limited Liability Companies (LLCs) are similar because they provide liability protection for business owners and allow for pass-through tax treatment, there are many differences as to how they are operated, complied with, and taxed. It’s best that your TFG tax professionals educate you on entity advantages to assist you in making the best decision when it comes to choosing which entity option is best for your business. Each business is unique, and often when there is more than one business owner, individual goals may vary. As the business grows and becomes more complex, one strategy may make more sense depending on the circumstances. Call us at 855-542-7537 to discuss the best option for you and your business.
