Technically speaking, an S-Corporation is a closely held business entity that has made a certain IRS election for tax purposes. Specifically, an S-Corporation has made an election under Subchapter S of Chapter 1 of the Internal Revenue Code to be taxed in a certain manner.
A person interested in launching a new business, or restructuring an existing one, may want to consider an S-Corporation. There are pros and cons to this type of business structure.
Tax Benefits of an S-Corporation
A key positive element of an S-Corporation is associated with profit and payroll tax implications. An S-Corporation is not taxed itself. Unlike a traditional corporation, an S-Corporation does not pay federal income taxes.
The tax liability that otherwise would be paid by a corporation is passed through to the owners of the enterprise. The shareholders of the S-Corporation individually are responsible for this tax liability. Thus, the company escapes double taxation.
This differs from a more traditional corporation, also known as a C-Corporation. With a traditional, or Subchapter C corporation, federal taxes are imposed on both the corporate and the shareholder levels. Thus, with an S-Corporation, corporate taxes are avoided all together on the federal level.
Limited Number of Owners
One of the potential drawbacks of an S-Corporation is that there is a limitation to the number shareholders that can be a part of the enterprise. Therefore, while an S-Corporation works well for a closely-held business, with only a limited number of owners, it does not accommodate an IPO.
The number of permissible shareholders has increased in the past two decades. With that said, there can be no more than 100 shareholders in an S-Corporation. While this is a large number in a closely-held business enterprise, for a business with shares that publicly are traded, an S-Corporation is not a suitable vehicle because of this limitation.
There is one caveat to the 100 maximum number shareholders. Spouses are counted as one for the purposes of tallying shareholders. In addition, family members descended from a common ancestor are considered one unit for the purpose of totaling up shareholders.
Another benefit of an S-Corporation is that it provides its owners liability protection for the owners. In other words, provided the corporation is properly constituted, and is being run like a true corporation, its owners are not exposed to liability for the acts and conduct of the enterprise.
For example, if a person is injured because of a product made by an S-Corporation, the shareholders or owners are not exposed to liability for those injuries, as a general rule. In addition, the owners are not legally responsible for debts incurred by an S-Corporation in most cases.
For decades, the basic understanding was that a corporation was a legal entity that provided a liability shield, but was burdened with double-taxation on both payroll taxes and income taxes. However, with the innovation of the S-corporation, it is possible to enjoy the benefits of liability protection without Uncle Sam double-dipping. If your proprietorship or partnership has enough profit to justify the legal expense and hassle of setting up an S-corp, and you have no intention of trading your stock publicly, this structure may be an effective solution for safeguarding your assets.