S Corporations

An S corporation is a corporation which has elected to have its profits pass through to is shareholders in the same manner as a partnership or sole proprietorship.  The shareholders of an S corporation receive the benefit of limited liability, and are treated in the manner of partners for purposes of taxation.  An S corporation requires Articles of Incorporation be filed with the Secretary of State of Minnesota.  An S corporation issues stock and is governed as a corporation. The owners, referred to as shareholders, have the same protection from liability as shareholders of a C corporation. Shareholders in an S corporation have no personal liability for business liabilities. 
However, not all businesses qualify to be an S corporation.  To qualify as an S corporation, the corporation:

• May have no more than 75 shareholders, all of whom are individuals, estates, or qualifying trusts;

• Must have only one class of stock (although differences in voting rights may be allowed);

• Must be formed in the United States; and

• All shareholders must be citizens or residents of the United States. Non-resident aliens may not hold shares.

Advantages of Setting up Your Business as an S Corporation

• Limited Liability: The most significant advantages of converting a sole proprietorship or partnership to an S corporation are limited liability.  An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities of the corporation. In a sole proprietorship or general partnership, owners and the business are legally considered the same—leaving personal assets vulnerable.

• Pass-through taxation: An S corporation does not pay federal taxes at the corporate level.  Any business income or loss is "passed through" to shareholders who report it on their personal income tax returns.

• Losses: Corporate losses may ordinarily be passed through to the shareholders, who can then claim a deduction from their other taxable income.

• Tax-favorable characterization of income:  S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.  A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.

• Straightforward transfer of ownership. Interests in an S corporation can be freely transferred without triggering adverse tax consequences.  The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.

• Ability to raise capital: Operating as an S corporation may help a new business establish credibility with potential customers, employees, vendors and partners because they see the owners have made a formal commitment to their business.

• Easier Tax Accounting: tax accounting is easier for an S corporation than for a partnership or LLC.

Disadvantages of Setting up Your Business as an S Corporation

• Fewer investment opportunities: Unlike a C corporation, the S corporation may not be the subject of a public offering.

• No flexibility in allocation of profits: unlike an LLC, profits are allocated in proportion to each shareholder's ownership interest in the corporation.

• No deduction of fringe benefits: S corporations may not deduct the cost of fringe benefits granted to employees who have more than a 2% ownership interest in the corporation.

• Shareholder must be U.S. citizens or permanent residents:  Businesses who wish to seek foreign investors may be burdened by the residency restrictions on shareholders.

• Formation and ongoing expenses. S corporations have a higher cost of doing business that sole proprietorships and general partnership sue to recordkeeping and paperwork requirements by the state.

• Tax qualification obligations. Mistakes regarding the various election, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status.

• Stock ownership restrictions. An S corporation can have only one class of stock, although it can have both voting and non-voting shares. Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights.

• Closer IRS scrutiny: Because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality. As a result, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.

• Less flexibility in allocating income and loss: Because of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders.
  Taxation: Under normal circumstances an S corporation does not pay corporate income taxes. Instead, the corporate profits are passed through to the shareholders, who report the distribution on their individual tax returns. Many small business owners whose businesses generate significant profits choose to incorporate as an S corporation to avoid paying self-employment taxes on all of their income.
  Klun is here to assist you with the paperwork, formation of an S corporation, establishing by-laws.  These documents are complicated and we are here to assist.  Call us today for an appointment.