Choosing a Subchapter S Corporation for Your Corporate Structure
Becky Anderson, of Ogden, has been researching business structures in preparation for organizing a wedding photography business that she plans to open. She’s certain she wants more asset protection than a sole proprietorship or partnership affords, but a “C” corporation seems a little overblown for her needs, so she’s narrowed her choices to a limited liability company or a subchapter S corporation (S-Corp).
“Limited liability companies seem to be the more popular business structure for small businesses these days,” she says. “They are a little sexier, but I like the tax advantages and asset protections of an S-Corp.”
Indeed, limited liability companies are the business entity of choice by entrepreneurs today, but there are a few reasons why an S-Corp may be preferred.
When a general corporation makes a profit, it pays a federal corporate income tax on the profit, and if the company declares a dividend, the stockholders must report the dividend as personal income and pay even more taxes. Think “double taxation” here. S-Corps, on the other hand, avoid "double taxation" because all income or loss is reported only once on the stockholders’ personal tax returns. For many small businesses, the S Corporation offers the best of both worlds, combining the tax advantages of a sole proprietorship or partnership with the limited liability and enduring life of a corporate structure.
In Anderson’s wedding photography business, she’ll report profits and losses on her individual tax return. Since the IRS requires owners of S-Corps to draw a reasonable salary, she will have to pay herself regularly, for which she’ll owe all of the typical employment taxes: FICA, Medicare, federal and state, etc. However, any profits her company makes will be passed on to her as a “dividend” and will not be subject to FICA tax.
As an example, Anderson recalls reading that former Democratic presidential candidate John Edwards took a reasonable salary of $35,000 from his S-Corp and distributions of $500,000. Edwards’ situation may or may not be the benchmark of what is reasonable salary-wise, but if the IRS determines the owner or investor of an S-Corp is only taking distributions and not a reasonable salary, the agency will consider the move an evasion of FICA taxes and re-categorize some of the distributions into salary, for which FICA taxes will be assessed.
Reasonable salaries aren’t an issue with LLCs and sole proprietors, because ALL non-passive business income is subject to FICA tax. That makes the S-corp structure all the more appealing to Anderson. “At least I can limit the amount of FICA tax I have to pay,” she says.
In order to create her S-Corp, Anderson will have to take the following steps:
1. Draw up articles of incorporation and by-laws.
2. Incorporate the business as a corporation in the state where the company will conduct the bulk of its business.
3. Verify that the corporation meets the eligibility criteria for being an S-Corp.
4. Notify the IRS of her intention to be taxed as an S-Corp by filing IRS Form 2553 no later than the 15th
day of the third month following the date of incorporation.
While you don’t need an attorney or accountant to create the S-Corp, going that route can be less stressful and your accountant or tax advisor can help determine the corporate structure that is best for your business.
