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So you've decided to set up an S Corporation - Now What?


When electing to be taxed as an S Corporation, there are several important considerations to keep in mind:


1. Eligibility Requirements

  • Ownership Limits: S Corporations can have no more than 100 shareholders, and they must be U.S. citizens or residents.

  • Stock Classes: They may only issue one class of stock, meaning all shares must provide identical rights to distribution and liquidation.

  • Entity Restrictions: Corporations, partnerships, and certain trusts cannot be shareholders, limiting ownership to individuals, specific types of trusts, and estates.


2. Tax Benefits and Savings

  • Pass-Through Taxation: S Corporations are pass-through entities, meaning profits and losses are passed to shareholders’ individual tax returns, avoiding double taxation at the corporate level.

  • Self-Employment Tax Savings: S Corporation shareholders can take a portion of income as dividends instead of salary, reducing self-employment taxes. However, this requires paying a "reasonable salary" to any shareholder who is actively working for the corporation, as the IRS scrutinizes salary allocations.


3. Self-Employment Taxes on Salaries

  • Reasonable Compensation: The IRS expects S Corporation shareholders to receive a reasonable salary for the work they perform for the business. This salary is subject to employment taxes, which helps avoid abuse of the dividend-only approach.

  • Payroll Tax Compliance: With employees (including shareholders on payroll), an S Corporation must manage payroll taxes, including Social Security, Medicare, and unemployment insurance. This involves quarterly payroll tax filings.


4. State Tax Considerations

  • State-Level S Corporation Status: Some states don’t recognize federal S Corporation elections, meaning they may impose their own entity-level tax or require an additional state-specific election.

  • State-Specific Tax Obligations: Certain states impose franchise taxes or minimum annual fees on S Corporations, and these can impact overall tax savings.


5. Loss Deduction Limitations

  • At-Risk Limits: S Corporation shareholders can only deduct losses up to the amount of their investment in the corporation. If the shareholder has personally guaranteed any debt for the corporation, that amount is included in the at-risk amount.

  • Passive Activity Limits: Losses from passive activities (like real estate holdings in some cases) may be limited and can only offset passive income.


6. Administrative Burdens

  • Complex Tax Filings: S Corporations file IRS Form 1120S, and shareholders receive a Schedule K-1 that reports their share of income, deductions, and credits.

  • Corporate Formalities: S Corporations must adhere to corporate formalities, such as holding regular meetings, keeping minutes, and maintaining a board of directors to preserve liability protection.


7. Restrictions on Growth and Funding

  • Capital Limitations: Since S Corporations are limited to 100 shareholders and can issue only one class of stock, it may be more challenging to raise capital compared to other structures that offer preferred stock or a broader range of ownership.

  • Investor Limitations: Venture capitalists and institutional investors typically avoid S Corporations due to ownership and stock limitations, making it less attractive for high-growth companies that need substantial funding.


8. Potential for Double Taxation on Certain State-Level Income

  • Nonresident State Taxes: If an S Corporation has income in multiple states, shareholders may be subject to nonresident income taxes, and not all states offer credits for taxes paid to other jurisdictions, potentially creating some double taxation at the individual level.


Each of these factors affects the practicality and financial benefit of an S Corporation election, so it’s generally best to reach out to Naperville CPA to weigh the pros and cons based on your specific circumstances.


Using an S Corporation (S Corp) provides several tax benefits, making it an appealing choice for small businesses and entrepreneurs. Here are the main tax advantages:


1. Pass-Through Taxation

  • An S Corp doesn’t pay federal corporate income tax directly. Instead, the corporation's profits, losses, deductions, and credits pass through to its shareholders, who report these on their individual tax returns. This pass-through feature allows shareholders to avoid double taxation, which is common in C Corporations (where profits are taxed at both the corporate and individual levels).


2. Avoidance of Self-Employment Tax on Distribution

  • In an S Corp, owners can receive income as both salary and distributions. Only the salary portion is subject to payroll taxes (i.e., Social Security and Medicare), while the distribution is not. This can result in significant tax savings, as long as the IRS views the salary as “reasonable” based on the services provided.


3. Lower Audit Risk

  • S Corps are audited by the IRS less frequently than sole proprietorships and partnerships. The IRS often scrutinizes businesses where there is a mix of earned income (salary) and passive income (distributions), and an S Corp structure can help reduce exposure to audits when set up properly.


4. Deductible Fringe Benefits

  • Certain employee fringe benefits, such as health insurance premiums, retirement plan contributions, and other benefit costs, are deductible by the S Corp and can reduce the taxable income passed through to shareholders.


5. Section 199A Qualified Business Income Deduction

  • S Corp shareholders may also qualify for the 20% Qualified Business Income (QBI) deduction under Section 199A, which allows eligible taxpayers to deduct up to 20% of their business income. However, this deduction is subject to limitations based on income level, industry, and type of services provided.


6. Ability to Deduct Losses on Personal Return

  • If an S Corp incurs losses, shareholders can potentially deduct their share of those losses on their individual tax returns. This can help offset other income, which can be beneficial, especially for new businesses or those facing economic challenges.


7. Flexibility with State and Local Taxes (SALT) Cap Workaround

  • Many states allow S Corps to elect to be taxed at the entity level rather than as a pass-through, offering a workaround for the federal SALT deduction cap. This can enable shareholders to indirectly deduct more of their state and local taxes on their personal returns.


While the S Corp structure offers significant tax benefits, the setup has specific requirements, such as limits on the number and type of shareholders, and compliance obligations. Consulting with a tax professional can help ensure it aligns with your business's goals.

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