ABC's of S-corps
More Subchapter S Corporations (S Corps) have been filed in the history of the United States than any other business structure. S Corps are entities that meet their namesake subchapter of the IRS Internal Revenue Code. Contrary to popular belief, an S Corp is not a business entity. Rather, it is a tax election created by congress in 1958.
Advantages and benefits of S Corp status
S Corps are beneficial to real estate professionals and small business owners. If your business makes a minimum of $40,000, an S Corp may be beneficial because that income and loss will flow through to your personal tax return. This could save you thousands of dollars in tax. If you pay yourself a salary, you’ll be exempted from paying self-employment tax, which is an additional 15.3% tax on your income. Usually, the 15.3% tax comes out of your payroll and unemployment tax through FICA.
If you have a standard LLC, you pay taxes on the cashflow that comes in and then pay an additional 15.3% self-employment tax. When you have an S Corp, you don't pay the additional 15.3% tax because you're paying yourself a wage.
Not only can you pay yourself a salary, but you can also take a distribution of the income from your company without running it through payroll. In so doing, you won’t be paying distribution or unemployment tax. The distribution gets taxed at your standard federal tax rate. Therefore, it allows you to increase your gross income. Very few people are aware of this benefit.
Many small businesses have a decent income, and building an S Corp is a great option for them. If you’ve just formed your business and you don’t anticipate a sizeable income, don’t worry. You could register as an LLC and file for an S Corp the following year.
How taxes are handled
When you have S Corp status, taxes flow through to your personal tax return. So, the income and losses are reported on a Schedule K-1 federal tax document. Your S Corp will issue a K-1 to you as the shareholder. Then, you and other shareholders will report the K-1 on your personal income tax return. You must prioritize issuing the K-1 earlier to ensure that personal tax returns are filed on time.
It’s important to know that an S Corp gives you the same liability and asset protection as a C Corp or an LLC. Liability protection means that if you do something in the business’s name, liability will be limited to the business, not to you. Personal asset protection means businesses losses won't affect your personal assets or savings. Liability and asset protection are only valid IF you run your business well and have not signed any personal guarantees.
Caution: Take this as my little “beware of the IRS” sign – Do not pay yourself a minimal salary! You can’t pay yourself a $25,000 salary and then take $80,000 as a distribution. That is going to be a huge red flag to the IRS, and they’ll come looking.
Compliance requirements
To qualify for this tax election, you must first form as an LLC or a C Corp. Once you’ve registered as either of these business entities, you can file additional paperwork to get an S Corp election with the IRS. To get an IRS approval for S Corp status, your company must be formed within the United States and have no foreign individuals as shareholders.
When you have an S Corp, you can have a maximum of 100 shareholders. With this business structure, you cannot have a corporation or a partnership as a shareholder. And unlike other companies, you can issue only one class of stock with an S Corp.
The overview process
Starting an S Corp is a two-part process. It’s quite a simple process, but that’s probably because I do it all the time for clients in all 50 states. It may be confusing if you're not an attorney or a tax professional. So, you need to trust your attorney to handle it for you.
1. Register as an LLC or a C Corp. You may want to consult with a tax advisor to see if one is better for you.
2. File the relevant form with the IRS. When filing with the IRS, you’re essentially saying that you want your business taxed as an S Corp. The IRS will then approve the form if it meets the requirements.
It is much easier to plead your case if you have filed for tax returns. A lot of people start companies when they have little to no personal income, which can affect the IRS’s approval or denial of their application.
Annual reports
Many people forget that they need to do annual compliance with the state where they registered their LLC or C Corp. Your annual report is typically due a month before the anniversary of forming your business. It’s a simple report telling the state that you’re still conducting business, and it includes your business address and shareholders. You can file the form with your state’s office. In Illinois, it’s the Illinois Secretary of State. In other places, it could be the Business Revenue Office.
You must have a Registered Agent residing in the state where you are incorporated. A Registered Agent is a person or entity that accepts the process of service on behalf of the state or anybody who's trying to sue you. It's the person who accepts legal and state documents on your behalf.
Finally, you must have an annual meeting and keep detailed minutes. If you form as an LLC and then choose an S Corp election, your members turn into shareholders. As such, you need to have an annual meeting with them. If you’re the sole proprietor of your S Corp, you obviously won’t have meeting minutes. However, you need to document major decisions and keep the record in a corporate file. The corporate file will serve as your minutes.
So, how much is a reasonable salary?
It is an IRS and legal requirement that you pay yourself a reasonable salary, but ‘reasonable’ will depend on your industry and experience. Your scope of duties and business location also inform your income level. Since the cost of living varies with each state, similar job descriptions may have completely different salaries. So, several factors contribute to the determination of a reasonable income. You can research similar roles in your state to see how much people with your experience earn, on average. As a business owner, you’ll also need to apply discretion. You can’t pay yourself a reasonable salary if your company doesn't make any income.
Looking to file for S Corp status? Click HERE to see our packages for LLC and C Corp formation. There's an add-on for an S Corp, for just under $85. Or schedule a consultation so that you get the right information for you! You can also find FREE downloads HERE.
Check out my video on the ABC’s of S-corps below for more info!
