What is an S-Corporation?
If you're in the process of incorporating your business, I'm sure you've read articles about S-Corporations. So now you're ready to incorporate and you're having trouble understanding and differentiating a Limited Liability Company, a C-Corporation and this new S-Corporation status you've read about.
First and foremost, an S-Corporation is not technically a business formation you can create in the State of Missouri; or any state for that fact. What I mean by that, is you can’t go to the Missouri Secretary of State’s website and form your company as an S-Corporation. Instead, an S-Corporation is a special type of taxation status your already formed company chooses to elect. This election can, in some instances, help save your company and its owners on taxes. This election is created through a tax election with the Internal Revenue Service.
In order to elect to have your company taxed as an S-Corporation, you first need to incorporate your company; generally as a Limited Liability Company or a C-Corporation. Next, all of the shareholders will need to fill out and sign the election; IRS Form 2553.
Let’s say you incorporate your company as a C-Corporation and then elect to be taxed as an S-Corporation. Not, according to the IRS for tax purposes, all of the income and losses of your C-Corporation now passes through to the owners.
Advantages of an S-Corporation
Some of the advantages to electing S-Corporation status are (1) protected assets; (2) pass-through taxation; (3) favorable characterization of income; and (4) easy transfer of ownership.
Protection of Assets: The personal assets of an S-Corporations shareholders are protected, so long as the shareholder has not made a personal guarantee on behalf of the S-Corporation. Creditors of the S-Corporation cannot attack the shareholders home or bank accounts in order to redeem S-Corporation debits.
Pass-Through Taxation: The S-Corporation does not pay federal taxes at the corporate level and all business profits and losses pass through to the shareholder personal income tax returns. Another advantage to income and losses passing through to the shareholders personal income taxes is it has the ability to offset income generated by the shareholder in other business ventures. By choosing S-Corporation status, your company can avoid the dreaded double taxation of a C-Corporation.
Favorable Characterization of Income: Shareholders of the S-Corporation can also be employees of the company and receive a salary from the company as an employee. In addition, the shareholder/employee can also receive dividends from the S-Corporation. With the different characterizations of income (salary vs. dividends), this can help the shareholder/employee reduce his or her self-employment tax liability while gaining a business-expense and wages-paid deduction through the S-Corporation.
Transfer of Ownership: The shares of an S-Corporation can be bought and sold, freely, without any tax consequences. Let’s say, for instance, you have a Limited Liability Company and you sell 60% of your ownership. Because this sale is a transfer of more than 50% of the Limited Liability Company’s ownership, it can trigger a termination of the Company.
Disadvantages of an S-Corporation
Although there are some very attractive advantages in electing to be taxed as an S-Corporation, like anything, there are some disadvantages to making the election as well. Some disadvantages include (1) ongoing filings and fees; (2) stock ownership restrictions; (3) IRS scrutiny; and (4) reasonable salaries to shareholder/employees.
Ongoing Filings: In order to elect S-Corporation status, as explained above, you will need to form your company first. In the case of a C-Corporation electing to be taxed as an S-Corporation, you will still be required to follow all the regulations and filings in the State of Missouri. The company will need to hold required meetings and will need to file annual reports. In the State of Missouri, the C-Corporation annual filing fee is $20 when filed online and biannual filing fee of $40.00 when filed online.
Stock Ownership Restrictions: An S-Corporation can have no more than 100 shareholders and all of the shareholders must be U.S. citizens and residents. S-Corporations also cannot be owned by a C-Corporation.
IRS Scrutiny: Due to the advantage of differentiating salary and dividends, to lessen the shareholder/employees tax burden, the IRS may look at companies with an S-Corporation status a little closer than other companies. In some instances, the IRS can recharacterize dividends as wages, and subjecting those newly characterized wages to employment tax.
Reasonable Salaries: As a shareholder/employee, you will be required to pay yourself a “reasonable salary” and pay employment taxes on those wages. Now, the IRS has not made a bright-line ruling as to what a “reasonable salary” is and therefore it can all depend on a number of factors. For instance, if you run a multi-million dollar company as a shareholder and only report wages of $10.00 an hour and a dividend of $500,000, you may have some IRS auditors knocking on your business doors.
Making the determination to be taxed as an S-Corporation has quite a few factors that play into the decision. If you’re interested in learning more about S-Corporation taxation status, contact Howard Law at (314) 325-9868 and let us help guide you through the process and assure your company is legally protected.
About The Author
Evan M. Howard is the managing attorney for Howard Law, a St. Louis business law and criminal defense law firm based in Clayton, Missouri. Howard Law is focused on giving honest, quick and effective representation to all of its clients. With a background in business and experience dealing with tough criminal prosecution cases, Howard Law is ready to help guide you through your legal matter.
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