Americans are known for inventiveness and creativity around the globe. When economic times are tough, many people look within themselves for ways turn things around. For many of those individuals, starting their own business is their avenue to a better tomorrow. Sometimes this takes the form of a group of colleagues, displaced by an office closure, coming together and starting their own business to serve the same customers they previously had. At other times, a displaced individual may assess their skillset and pivot their career in a direction that serves a new need in the community, like the people and businesses who have turned their sewing skills into mask production during this pandemic.

While many of those mask-making individuals have taken up the call voluntarily, others have used this opportunity to save their businesses or start a completely new one. When these events happen, the wise counsel of a qualified tax professional can make a huge difference in how much these new business owners pay in taxes, face in liabilities and how well they are financially prepared for the future. While there are many factors that come into starting a business, in many situations, S corporation organization is the best approach.

S corporation defined

An S corporation is a corporation that has filed articles of organization with a specific state to establish itself as an eligible domestic corporation and then also elects S corporation treatment. Filing the articles of organization establishes the business as a separate legal entity from the taxpayer. The S corporation election makes that entity a pass-through entity, meaning all income and expenses pass through to the individual shareholder(s) and are reported on the shareholder’s personal tax return.

Advantages and disadvantages

There are both advantages and disadvantages to this organization. Making sure your client is aware can sometimes be a challenge when the excitement of starting their business might also cloud their judgement. For your convenience, here is a list of a few key advantages and disadvantages you can use to highlight these matters and guide a conversation with your client. This is by no means an all-inclusive list. This is a list to start down the thought path of whether or not to choose this option with your client.

Advantages

• Shareholders have limited liability.
• There is no double taxation, as there is with C corporations, because the S corporation’s income is passed through to its shareholders and increases their stock basis.
• Pass-through income is taxed at the individual’s tax rate, which could be as low as 0%-12%. In addition, pass-through income is not subject to self-employment tax.
• Long-term capital gains rates apply.
• The shareholder is generally eligible for the qualified business income deduction on their personal tax return if the S corporation has qualified income.

Disadvantages

• Corporations, partnerships, nonresident aliens and certain trusts cannot be shareholders.
• Generally, an S corporation must have a calendar year, unless it has a business purpose fiscal year or elects a tax year under §444.
• The tax rate on pass-through income may be higher if the shareholder is in a high-income tax bracket, such as 37% for individuals when compared to 21% for corporations.
• Shareholders/employees who own more than 2% of the S corporation’s stock must pay tax on a number of fringe benefits that are tax-free to shareholders/employees of a C corporation, such as:
  • Employer contributions to certain accident and health plans
  • The cost of up to $50,000 of group-term life insurance
  • Meals and lodging furnished for the convenience of the employer
• Shareholders must take reasonable compensation as wages, subject to federal and FICA withholding.

How to set up an S corporation

As mentioned previously, the first step in creating an S corporation is to file articles of organization for the state where the business is located. This is usually the state where the taxpayer lives; however, if the taxpayer lives near a state border and will be operating primarily in the other state or may be looking to secure state or municipal contracts, organizing in the other state may be beneficial. Once the articles of organization have been filed, you or the client needs to file the Form 2553, Election by a Small Business Corporation.

Timing of filing Form 2553 is very important. Form 2553 must be filed within 2 months and 15 days after the beginning of the tax year that the election is to take effect or at any time during the tax year preceding when the election will be in effect.

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Here we have looked at what an S-corp is, the advantages and disadvantages, and how to set one up. To learn more about S corporations, consider our self-study guides. We will also be hosting an upcoming online workshop, worth 8 CPE, called Preparing S Corporation Returns on Aug. 27.