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Why an S corporation could be your best bet

(Content provided by Microsoft)

Why does any startup entrepreneur incorporate a business? Is it for prestige, or to seem like a bigger company right away?

Those aren't bad reasons. But most knowledgeable entrepreneurs place their best new-business ideas into a corporate structure to protect personal assets from unexpected business liabilities. In other words, they want to play it safe.

The problem with this prudent, liability-limiting strategy is that owners of especially profitable businesses end up paying double taxes-first on corporate business profits and again on any dividends paid to shareholders. Owners also lose the opportunity to write off business losses against other personal or joint income as they could in a sole proprietorship business structure.

Fortunately, there is a way to incorporate so that startup entrepreneurs can minimize taxes plus keep their personal bank account away from business creditors. The answer is ... an S corporation.

How S corporations work

Like standard C corporations, S corporations shield owners' personal assets from unpaid debts and other business liabilities. But unlike standard C corporations in which double taxes are paid on corporate profits and then shareholder dividends, an S corporation is exempt from most corporate taxes.

So, who pays the federal income taxes on S corporation profits? The S corporation's shareholders.

Here's how it works: The IRS allows S corporation profits and losses to bypass corporate taxes. The S corporation's net profits and losses are divided up on a pro-rata basis and then distributed to its individual shareholders. So, the money-saving advantage of an S corporation for small-business founders and shareholders is the opportunity to pay income taxes on business profits only once and at lower personal income tax rates too.

Can it be too good to be true?

With S corporations, the devil is hidden in the details. There are a number of treacherous gotchas that can make a C corporate status or other types of business structures more viable than an S corporate status. Plus, some tax-hungry large states such as New York and California are finding ways to collect extra taxes on S corporations. Here's what startup entrepreneurs need to know.
  • Losses are limited. The IRS is on the hunt for entrepreneurs who create businesses that are largely designed to generate big losses, year after year. But unlike a sole proprietorship, which has few restrictions on personal income tax write-offs, the IRS limits losses in an S corporation to the owner's "basis," which is typically the cash or property invested in the business.
  • Shareholder counts are limited, too. Whereas standard C corporations and limited liability companies can have an unlimited number of shareholders, S corporations are limited to 100 shareholders (married couples can count as one). This makes a public or large private offering to raise funds out of the question.
  • Only United States corporations are eligible. Foreign companies that operate in the U.S. can't elect to be S corporations for tax-saving purposes.
  • Only one class of stock can be issued. This requirement essentially shuts down funding from venture capital funds, and from knowledgeable private investors, since these investors typically insist on receiving a separate "preferred" class of stock with benefits over common shareholders.
  • No corporate investors are allowed. S corporation shareholders must be U.S. residents, estates, or certain trusts and partnerships. Today, large corporations in all industries view smaller entrepreneurial entities as a strategic source of innovation and market opportunity. Entrepreneurs who want to develop partnerships with U.S. or foreign corporations that involve equity won't meet the IRS test as an S corporation.
  • Employment tax-saving loophole has been closed. S corporations have long been used to reduce the employment taxes associated with S corporation shareholders who also draw a salary from the business. To save on employment taxes, savvy S corporation shareholder-employees divide their compensation in two components: a modest salary where employment taxes are collected, and one or more dividend payments in which no employment taxes are collected. To close this loophole, the IRS now requires shareholder-employees to pay themselves at least a reasonable "market" salary before distributing dividends.
  • Reinvestment of net earnings is complicated. With an S corporation, the IRS assumes that all net profits are distributed to the company's shareholders at the end of each year. But what if an S corporation doesn't want to distribute its profits to shareholders? What if the S corporation would like to reinvest the company's net profits back into the company to fund business expansion projects?
    Of course, owners can choose this path. However, the IRS will still expect to collect taxes on each owner's share of an S corporation's net profits even if no cash is actually paid to shareholders. This nasty little tax-collecting maneuver is called the "phantom income tax." It's called that because shareholders owe taxes even though they never really "see" or receive the hard cash, because the excess profits are invested back into the business.

    The common work around to phantom income taxes is for S corporations to pay out just enough dividends each year to cover each shareholder's tax obligations.

S corporations remain very popular

You would think that all these rules would dissuade entrepreneurs from selecting an S corporation for their new business endeavor. Actually, since 1997, S corporations have been the most popular form of corporate tax return filed with the IRS.

Entrepreneurs who want to elect S corporation status for their corporation must file Form 2553 with the IRS. All shareholders of the corporation must sign this form.

Fortunately, the IRS is practical enough to allow business owners the flexibility to convert a C corporation to an S corporation, or an S corporation to a C corporation, for income tax filing purposes. This change in status should only be considered with the guidance of qualified tax-planning experts. One way or another, the IRS will look for opportunities to collect taxes, even back taxes, when entrepreneurs change their minds.


 
 
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