As far as I know, everyone wants to make money, but no one wants to pay taxes. Yet we all know that taxes are inevitable: All we can do is make smart decisions to (legally) minimize the amount of taxes we owe.
When it comes to small businesses, startups, and entrepreneurs, the choice in business structure has a big impact on the amount of taxes paid and the manner in which they’re paid. The biggest difference is whether the business itself pays taxes on profits, or whether those profits are passed on to the business owner(s).
A typical C corporation is taxed as its own entity. Every year, the corporation must file Form 1120 to report its income, deductions, and credits. Any profits are taxed at the corporate level using that year’s tax rate tabler.
If any of the corporation’s profit is distributed to the shareholders as dividends, those dividends are taxed on the shareholder’s individual tax return. This can create a double tax, which can end up stinging some entrepreneurs who want to take money out of the business as a dividend.
That’s where “S corporation” election comes in. A corporation can file a special election with the IRS (known as S Corporation election). An S corporation is not subject to corporate income tax. Instead, any profits are passed along to the shareholder’s personal tax return. If you own 50% of an S corporation, then you are responsible for reporting 50% of the corporation’s income on your personal tax statement.
S corporation election and startups
If you are in the process of building a startup, you’ll need to think about your company’s business structure. If you are evaluating whether to be a regular C corporation or an S corporation, here are a few things to think about. Keep in mind that this is general information and it’s always smart to speak with an expert about your particular situation.
1. With S corporations, shareholders are able to pass the losses in a year to their personal income reporting. If you’re just starting out and anticipate a loss, then an S corporation can let you report the loss and offset any other income (i.e. if you have a “day job” and are building your startup in your spare time).
2. With an S corporation, any income gets passed along to the shareholders based on their ownership percentage; this is true whether the individuals actually take that money or not. So, if you plan on keeping your startup’s profits in the business and not passing it all out in dividends, then the C corporation may be better.
By contrast, if you are looking to move the profits out of the business to yourself and other founders/shareholders, the S corporation election can save you from the double taxation mentioned above.
3. If you are planning on seeking VC funding right away, then a C corporation can be preferable. VC investors strongly prefer the C corporation structure, since it lets you manage multiple classes of stock and easily transfer stock.
Keep in mind that some startups do elect S corporation in the beginning when they’d prefer the pass-through tax treatment, then convert to a C corporation when it’s time to start looking for funding. This can be done by voluntarily revoking your S corporation election with the IRS.
S corporation and solo consultants
S corporation election can also apply to solo consultants, contractors, and service providers. In my experience, these individuals tend to have two concerns when it comes to business structure: paperwork/legal formalities and self-employment taxes.
A corporation has a higher level of paperwork and legal obligations than the sole proprietorship, partnership, or Limited Liability Company (LLC). For example, a corporation needs to have formal meetings and keep meeting minutes, etc. This can be administrative overkill for the solo worker.
In addition, a sole proprietor or single member LLC is considered self-employed by the IRS and needs to pay self-employment taxes (that are equal to the sum of employer/employee FICA and Medicare tax).
Some self-employed individuals opt to form an LLC and then elect S corporation tax treatment. The LLC still gives them personal liability protection, but with a lot less paperwork than the corporation. In addition, the S corporation status gives the option of dividing up the business’ earnings into both salary and distributions. Salaries are subject to FICA tax (social security and Medicare), but the distributions are not. As I mentioned above, a tax advisor or small business expert can help you decide if this is the right course of action for your own situation.
S corporation deadline is approaching
If you choose to elect S corporation tax treatment, be aware that it’s time sensitive. For a brand new company, you have two months and 15 days after your company is formed to file the election. If you have an existing business, you need to get your paperwork in within the first two months and 15 days since the start of your tax year (that’s March 16 if you report on the calendar year).
There are some important requirements that a business needs to meet in order to elect S corporation status. For example, you can have no more than 100 shareholders, and all shareholders must be U.S. residents.
If you are interested in electing S corporation treatment, check out IRS Form 2553. It’s relatively simple paperwork and in certain situations, can mean significant savings for your business.
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