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What Is an S Corporation and Should I Form One?

Contrary to popular belief, the S corporation is not a distinct entity type. An S corporation is either a corporation or a limited liability company that has elected treatment as a pass-through entity for federal income tax purposes under Subchapter S of the Internal Revenue Code. This tax election allows the entity to enjoy a unique combination of benefits if it meets the following requirements, with some limited exceptions:

  • it has less than 100 shareholders 

  • all of its shareholders are U.S. citizens, residents, special trusts, or certain estates

  • it has only one class of stock

  • its membership is not comprised of any partnerships or corporations

Benefits

The S corporation appeals to business owners for a number of reasons:

  • Pass-Through Taxation. Unlike most corporations that are taxed at both the entity level and shareholder level, S corporations elect to pass corporate income losses, deductions, and credits down to the shareholders alone. This appeals to many business owners who intend to reinvest their companies’ profits back into the business. When they do, they are not penalized by being taxed at the corporate level. They are, however, still required to file annual tax returns.

  • Self-Employment Tax Savings for Owners. Another major benefit of an S corporation are the tax savings enjoyed by owners who also work for the business. Unlike other pass-through entities, where self-employment tax is due on all pass-through income, owners of S corporations are not required to pay self-employment taxes on their distributions; the salary is the only component subject to self-employment tax. Self-employment taxes are Medicaid and Social Security taxes that an employer and employee pay the government. For S corporations, owners do not have to pay self-employment taxes on any profits remaining after they have paid themselves a “reasonable” compensation. The Internal Revenue Code does not define what is reasonable; courts often consider what similarly situated professionals are paid in a particular region as well as how much time and effort is required to complete the role at hand.

  • Qualified Business Income Deduction. The 2017 Tax Cuts and Jobs Act allows pass-through entities to take advantage of the Qualified Business Income Deduction of up to 20%. Qualified Business Income (QBI) is defined as the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business. There are many rules and exceptions for determining the deduction. An owner must therefore carefully calculate QBI and determine how the business’s specific industry may impact eligibility and deductions.

Limitations

Individuals who are most likely to elect taxation as an S corporation understand its legal and financial structure and have determined that the benefits outweigh the limitations. When deciding whether to form an S corporation, ask the following questions:

  • Does my business meet the basic requirements for an S corporation?

  • Will I be working as an employee of the business?

  • What is considered reasonable compensation for the role I play in the business?

We Can Help

Exploring your taxation options of your business entity can be difficult and complex. Our experienced attorneys understand the various options available and will help you make the right choice. Call us today to schedule an appointment.  


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THIS ARTICLE SHOULD NOT BE RELIED ON AS LEGAL OR TAX ADVICE (INFORMATIONAL PURPOSES ONLY)


Ryan E. Snow, JD/MBA, is a licensed attorney and experienced entrepreneur specializing in legal services for small to mid-sized businesses in all industries and at all stages of growth and development. He can be contacted via email at Ryan@RyanSnow.com or at his website www.ModernUtahLaw.com.


©2023 by Venture Counsel LC, all rights reserved.


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