Whether you’re a new entrepreneur looking to start your first company or an experienced businessperson expanding into a second or third enterprise, launching a new business brings tough decisions.
Structuring the startup with tax purposes in mind is one of the most important decisions you’ll have to make in the startup process. Electing your start-up as an S corporation may seem like a savvy move for many business owners. But it’s often not the right decision for everyone. Consider these important points before you make any decisions.
What’s It All About?
An S corporation is a tax election available only to certain U.S. companies. To make the election, you’ll need to file IRS Form 2553, “Election by a Small Business Corporation,” typically within 75 days of forming the business or the start of the tax year to which you want the election to apply.
If you elect S corporation status, the IRS will treat your start-up as a “pass-through” entity. This means the business generally won’t pay federal income taxes. Instead, profits and losses will pass through to your individual tax return and those of other shareholders.
As a result, you’ll avoid the “double taxation” faced by shareholders of C corporations — whereby the company pays taxes on the business’ income and then shareholders pay tax on any dividends received. In addition, S corporation shareholders may be eligible for the Section 199A qualified business income deduction for pass-through entity owners. It was recently made permanent under the One Big Beautiful Bill Act.
Which Businesses Qualify?
IRS rules limit which companies can elect S corporation status. To qualify, your start-up must:
- Be an eligible domestic corporation or limited liability company (LLC)
- Have no more than 100 shareholders who must be U.S. citizens or residents (certain trusts and estates may also be eligible)
- Offer only one class of stock
Insurance companies, financial institutions using the reserve method of accounting, and domestic international sales corporations are generally ineligible.
Why Do It?
As mentioned above, the main advantage of electing your start-up as an S corporation vs. C corporation status is avoiding double taxation. But there are other reasons to do it.
For example, many start-ups incur losses in their first few years. S corporation status allows owners to offset other income with those losses, a tax benefit that’s unavailable to C corporation shareholders.
S corporations also have advantages over other types of pass-through entities. Generally, all trade or business income that flows through to sole proprietors and partners in partnerships is subject to self-employment taxes — even if the income isn’t actually distributed to the owners. S corporations can divide their income into shareholder-employee salaries and distributions. The salary portion is subject to payroll taxes, but distributions aren’t. So, by drawing a smaller salary (but one that’s reasonable in the eyes of the IRS) and taking the remainder as distributions, S corporation shareholder-employees can reduce their overall tax burden.
Liability protection is another advantage S corporations have over sole proprietorships and partnerships. S corporation status shields shareholders’ personal assets from business debts and legal claims, provided applicable rules are followed. Operating as an S corporation can also make your new business appear more credible to lenders, investors, and customers because of its formalized, protective framework.
What Are The Drawbacks?
Electing to be treated as an S corporation has its drawbacks. Your start-up will have to follow strict IRS rules, which include keeping up with filing requirements and maintaining accurate financial records. Failure to comply could lead to back taxes, interest, and penalties. It could even mean losing your S corporation status in a worst-case scenario.
Indeed, S corporations tend to incur higher administrative expenses than other pass-through entities. You’ll need to file corporate tax returns and meet state-level requirements. The extra complexity may outweigh the tax advantages — especially for newly launched companies with little to no profits.
Finally, it bears repeating: Although the salary/distributions income-splitting strategy mentioned above is advantageous, it can draw IRS scrutiny. Paying shareholder-employees an unreasonably low salary to avoid payroll taxes could trigger an audit with negative consequences.
Who Can Help?
If you’re thinking of launching your start-up as an S corporation, you’ll need to assess a wide variety of factors, including projected profits, the number of shareholders, and your comfort level with the administrative requirements.
Before you do anything, contact us. We can help you evaluate whether operating your start-up as an S corporation aligns with your strategic and financial goals. If it does, we’d be happy to assist you with the filing process and compliance going forward.
