BGBC Partners, LLP Tax Update: A Primer on S Corporations
Whether you are just starting out as a grocer, or your store is on the mature end of the business life cycle, it is always wise to consider and reconsider the best legal form to operate the business through. One of the more popular structures is the S Corporation. In this Tax Update, we will discuss some of the tax benefits and requirements associated with using an S Corporation, in an effort to help you evaluate whether this entity form is a fit for your business.
S corporations combine the limited liability of a corporation and the flow-through tax treatment of a partnership.
Why is the flow-through tax treatment important? Shareholders of a regular “C” corporation are subject to two layers of tax: one tax at the corporate level and the other at the individual level when funds are distributed. However, with an S corporation, business income or loss is passed-through to shareholders onto their personal tax returns thereby subjecting the income to only one layer of tax.
With an S corporation, there are also various retirement strategies which can be implemented such as establishing a SEP-IRA or a SIMPLE Plan. These plans allow for tax-deductible contributions while saving for retirement. Keep in mind though that some of these strategies can also be offered with other entity structures.
Another significant benefit of an S corporation involves the self-employment tax. With an S corporation, distributions are not subject to the self-employment tax. However, salary payments must be considered “reasonable” (in this case salary cannot be too low) or the IRS can try to recharacterize some of the distribution to salary and impose payroll taxes over several years. This flexibility in setting a reasonable salary contrasts with a general partner or sole proprietorship in which self-employment tax is imposed on net earnings from the business.
Regarding the requirements of forming an S corporation, first, there can be no more than 100 shareholders. Second, of these 100 shareholders, they must all be U.S. citizens or residents and must be a “natural” person although certain trusts can also be owners. This means that if any shareholder is a resident of another country, or if any shareholder is a corporation or partnership, the S Corporation election is not available. Finally, there can only be one class of stock available, although there can be voting and nonvoting stock. On this last point, the “one class of stock” rules can be tricky. Items which don’t appear to be a different class of stock might be construed to be by the IRS.
As you can see, there are very distinct advantages of using an S corporation, but certain requirements must be kept in mind. Contact your CPA in order to adequately evaluate which of the various entity forms fit best for your business.