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S Corporation – The Better Choice for Small Businesses

When small businesses incorporate, S corporation is usually the best choice. S corporations were set up by the Government due to the double taxation issues that C corporations – or general corporations – face. Instead of paying taxes at the corporate and personal level, income and expenses are passed directly through the corporation to the shareholders, in proportion to their stock ownership. If a shareholder owned only 15% of a corporation, he would only be liable for 15% of the corporation’s income and expenses on his personal income taxes.

There are many limitations placed on S corporations that would not be suitable for larger businesses, but usually suit small businesses very well. S corporations typically use a calendar year, as opposed to a fiscal year. They are limited to 75 shareholders, and those shareholders can only be individuals, or a qualified trust. In other words, insurance companies, banks, or other corporations cannot hold shares of the S corporation. However, one S corporation can own another S corporation, if the other S corporation is the sole shareholder. Furthermore, only domestic individuals and qualified trusts can hold shares in an S corporation. Foreigners cannot.

S corporations are operated much like C corporations in that they are formal entities requiring annual meetings of shareholders, meeting minutes must be recorded and kept, and the corporation continues even when shareholders die or leave the company. S corporations are favored by banks and investors, just as C corporations are. Capital can be raised through the sale of stock, as long as those sales don’t exceed the limitations and restrictions that have been set by the government.

S corporations can only issue common stock, as opposed to the different levels of stock that can be issued by C corporations. S corporation shareholders can opt to sell their shares, without approval from the boards as well. Even though income and expenses are passed directly through the S Corporation to the shareholders, funds that are retained by the company are not taxable as personal income, but as corporate income.

S corporations enjoy the same level of liability protection that is afforded to C corporations as well. The shareholders are not personally liable for any debts that are owed by the corporation, or for lawsuits. The corporation is a separate legal entity. Owners can opt to save on employment taxes by choosing not to have a salary, but to take their income in the form of distributions.

S corporations are set up exactly like C corporations, and it becomes recognized as an S corporation when IRS form 2553 is filed. But that form must be filed within a certain time frame, as set out by the government. Alternately, an S corporation can revert back to being a C corporation if it is no longer eligible to be an S corporation. For instance, if the S corporation has 75 shareholders, and then sells one or more shares to an additional shareholder, it is now a C corporation.

Even though S corporations are suited to small businesses, your business may not be suited to a corporation. In this case, you should strongly consider setting your business up as a limited liability company, as opposed to a sole proprietorship. This will give you the protection of a corporation, with the advantages of a sole proprietorship.