If you’re considering launching a business with partners, you may be wondering what type of entity to form—and an S corporation could be the most suitable form for your new business to take. Here are a few of the reasons why.
The biggest advantage of forming an S corporation (as opposed to a partnership) is that you won’t be personally liable for corporate debts as S corporation shareholders.
However, if you want to receive this protection, it’s important to make sure that:
- The corporation is adequately financed
- The existence of the corporation as a separate entity is maintained
- Any formalities required by your state are observed, including:
- Filing articles of incorporation
- Holding organizational meetings
- Adopting by-laws
- Electing a board of directors
S corporations and anticipated losses
For any business that expects to incur losses in its first few years, forming an S corporation is preferable to forming a C corporation from a tax standpoint. This is because C corporation shareholders get no tax benefit from such losses.
S corporation shareholders, by contrast, can deduct their percentage share of these losses on their personal tax returns, to the extent of their basis in the stock and in any loans you make to the entity. In addition, any losses that exceed a shareholder’s basis and can’t be deducted are carried forward, so they can be deducted later when there’s sufficient basis.
Income earned once an S corporation begins to earn profits is taxed directly to the shareholder whether or not it’s distributed. As such, it’s reported on your individual tax return and aggregated with income from other sources. The shareholder is also eligible to take the 20% pass-through deduction, subject to various limitations, to the extent the income is passed through to the shareholder as qualified business income. And while wages are still subject to Social Security taxes, shares of an S corporation’s income aren’t subject to self-employment tax.
If you’re planning to provide fringe benefits such as health and life insurance, you should also be aware that the costs of providing such benefits to a more than 2% shareholder are deductible by the entity but are taxable to the recipient.
S status: reasons for caution
It’s worth noting that S corporations can also inadvertently lose their S status if a partner transfers stock to an ineligible shareholder, such as:
- Another corporation
- A partnership
- A nonresident alien
In the case that the S election is terminated, the corporation then becomes a taxable entity— meaning that you wouldn’t be able to deduct any losses as an S corporation shareholder and your earnings might be subject to double taxation, both at the corporate level and when distributed to you. If you’re considering forming an S corporation, it’s generally good practice for each partner to sign an agreement not to make any transfers that might jeopardize the S election.
We can answer any questions you have before you finalize your choice of entity. Contact us today, and let us assist you in launching your new venture.