Farwah Jafri | December 8 2021
You’ve heard of private limited companies, public limited companies, and even LLCs. But what exactly is an S corporation? Many have never heard of it and those that have, really don’t have the first clue of what it is. An S corporation gets its name from the Subchapter S of the Internal Revenue Code (IRC). It has everything to do with how the corporation chooses to file taxes.
Similar to a sole proprietorship or partnership, the S corporation avoids double taxation and passes most of its profit revenue and losses to the shareholders. The shareholders must then declare these incomes and losses in their personal income tax filings. This way the taxes are subject to individual tax rates and income tax returns.
Which begs the question, why should entrepreneurs and corporation owners consider the S corporation model over others for their businesses? There are several advantages that we will discuss here. But first, let’s see how the formation of an S corporation occurs.
The first step in forming an S corporation is filing Articles of Incorporation, also known as Certificate of Incorporation, with authorities relevant to the state. Filing fees and initial franchise taxes may apply. The kind of information and documentation varies from state to state. After you have filed Articles of Incorporation, you need to file Form 2553 with the IRS. This is to elect S corporation status for your company.
Once this is done, your S corporation must hold an organizational meeting with the directors. Here you will adopt bylaws and undertake other initial corporate actions approving a resolution to open a business bank account. It is also advised that there should be a distribution of stock certificates to shareholders and these transactions should be recorded in the company’s stock transfer ledger. The actions and minutes of the organizational meeting should be documented and filed along with the Articles of Incorporation and by-laws in a corporate record book.
For specific questions refer to an attorney. If the whole process seems too overwhelming, you can contact us at Monily. We really do have the best taxation advisory team and also provide excellent bookkeeping services and tax filing.
The advantages of forming an S corporation are numerous and suited to companies and organizations when the issue of transfer of ownership comes forward. Though there are many advantages, we have highlighted the top 5 to summarize the benefits you can expect when forming an S corporation.
With an S corporation, a shareholder’s personal assets are secure. Creditors can not pursue shareholders’ personal assets. Business debts must be paid by the S corporation and not the shareholders. This level of protection is coveted and can be secured by forming an S corporation. It allows you to distinguish yourself from the corporation.
S corporations aren’t required to pay federal taxes at the corporate level. All incomes and losses are passed through to shareholders who must file them as incomes and losses on their personal income tax returns. The advantage here is that business losses can translate to offset income tax returns and thus reduce income tax paid. If the S corporation is a startup, this method of taxing can be extremely beneficial in the initial stages of setting the company up.
S corporation shareholders can be listed as employees of the company. They can draw salaries as employees of the corporation, receive dividends from the corporation, as well as other distributions that are tax-free. This is limited to the extent of their investment in the corporation. A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business expense and wages-paid deductions for the corporation. This might sound a little confusing but Monily’s taxation team can help you unravel the Gordian knot.
Corporations must use the accrual method of accounting unless they are small businesses. Small companies are considered small if they gross $5,000,000 of receipts or less. S corporations, however, don’t have to use the accrual method. The only exception being, if the S corporation had inventory.
The reason this is an advantage is because accrual accounting is more complicated. It requires more time and resources, and involves tracking of cash flow, accounts receivables, and accounts payables. It can also skew the short-term financial view of your company. Most small business owners don’t have that kind of time or resources to spare.
Cash accounting, on the other hand, is simple and easy to maintain. It’s easy to track how much cash the business actually has, at any given time. This is because the money is simply in or out of the S corporations bank account. The S corporation only has to pay tax on the money received, rather than on invoices issued.
In the initial days of a business, everyone wants to make sure their investment is secure. Many want to leave after a few months, and some want to buy others out. It is tricky and extremely complicated to do so with partnerships or LLCs, where a transfer of more than 50% interest can trigger the termination of the company. However, interests in an S corporation can be transferred easily and freely, without triggering adverse tax consequences. The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred. This is advantageous to all those investing because it gives them a clear way out without harming the corporation as a whole.
Startups and new businesses are more likely to be taken seriously as an S corporation in their specific industry. Many potential customers view it as a viable business. Employees are more likely to sign on, vendors are more likely to form a partnership, and collaborations with other businesses are more likely. S corporations lend new businesses more credibility and a stronger footing in their early years of operation.
We hope this simplifies the S Corporation enigma. For any related queries or other financial services please don’t hesitate to contact us or book a consultation with our professional accountant.
See Also: 5 Decisions That Will Increase Your Chances Of Building a Successful Startup
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.