When should your business become an S corp?
You may have heard the term “S corp” thrown out online by tax professionals and fellow entrepreneurs, and you know it’s a sign of growth that your little sole prop has made it into the big leagues. But, you have no idea what it means and why it’s significant. You might get it confused with other terms like “corporation,” “single-member LLC,” or “partnership,” and you might not understand how it could hinder your organization if you become one too soon.
What follows is a brief explanation of what a Subchapter S corporation is and when a small business should be inclined to become one. Hopefully, it pulls back the curtain on the jargon associated with the term.
An S corporation is a tax designation determining how your firm is viewed and treated by state and federal tax laws. Sole proprietorships, partnerships, and regular corporations (three different types of legal and tax entities) elect to become S corporations in order to be taxed in a certain way as prescribed by law. The designation permits your business to be viewed as a pass-through entity, allowing the profits of the business to be taxed at individual rates while maintaining a distinction between the business and the individual (or individuals) owning the business. For sole proprietorships, the benefits of an S corp designation include lower payroll taxes and autonomy, a characteristic deemed necessary by investors and creditors.
Although it is not difficult to become an S corp, it takes time and money to sustain the status and thus your small business should not become one until you are prepared to see it through. There are three indications you are ready for the change:
- Your business starts making a profit. New businesses often take years to start making a profit. And once they do, the proprietor realizes they are liable to pay taxes for the first time and usually when she least expects it. If your business is not making a profit, there is little use for an S corp status. Otherwise, the designation opens the door for tax-saving strategies involving the avoidance of payroll taxes.
- You want to pay yourself a salary. Strangely enough, you are not allowed to pay yourself a salary until your business is designated as a corporation or an S corporation. Some find no inconvenience with this rule, yet for others it limits their ability to budget, plan, and obtain personal credit. Banks often look unfavorably upon sole proprietors or independent contractors because of their inconsistent earnings. However, once these people present W-2 forms, proving their income, financial institutions are ready to extend credit. If you want to give yourself a steady wage and withhold payroll taxes on a regular basis, you are ready to become an S corp. Incidentally, paying yourself a salary is a tax-saving strategy with S corps. Owners/employees of an S corp are required by law to pay themselves a reasonable salary for the services they provide to their business. This salary is deducted from the income of the firm, and, unlike partnerships or sole proprietorships, the remaining profit is not subject to self-employment tax.
- Your business starts making a profit. New businesses often take years to start making a profit. And once they do, the proprietor realizes they are liable to pay taxes for the first time and usually when she least expects it. If your business is not making a profit, there is little use for an S corp status. Otherwise, the designation opens the door for tax-saving strategies involving the avoidance of payroll taxes.
- You want to pay yourself a salary. Strangely enough, you are not allowed to pay yourself a salary until your business is designated as a corporation or an S corporation. Some find no inconvenience with this rule, yet for others it limits their ability to budget, plan, and obtain personal credit. Banks often look unfavorably upon sole proprietors or independent contractors because of their inconsistent earnings. However, once these people present W-2 forms, proving their income, financial institutions are ready to extend credit. If you want to give yourself a steady wage and withhold payroll taxes on a regular basis, you are ready to become an S corp. Incidentally, paying yourself a salary is a tax-saving strategy with S corps. Owners/employees of an S corp are required by law to pay themselves a reasonable salary for the services they provide to their business. This salary is deducted from the income of the firm, and, unlike partnerships or sole proprietorships, the remaining profit is not subject to self-employment tax.
- You want to separate yourself from your business. S corp status allows and requires sole proprietors to separate themselves from their business beyond legalities. Once the designation occurs, the business keeps its own books and bank accounts and must file its own tax return. Autonomy makes a business appear stronger, more reliable, and more independent in the eyes of investors and creditors. You are ready for the transition if you want to draw a distinct line between you and your business. Separating yourself from your business is usually first accomplished by becoming a limited liability corporation, a legal entity not related to tax rules. It should be noted an LLC can become an S corp, and thus the two entities are not comparable. An LLC can be taxed as a sole proprietorship (which files form 1040, Schedule C), a partnership (which files Form 1065), a corporation (which files form 1120), or an S corporation (which files form 1120s). Many articles and professionals interchange the term “LLC” with “sole proprietorships” or “partnerships.” Be aware of the context they are using to determine whether they are speaking about legal liability or tax treatment.
What happens if you become an S corp before you need to?
In most cases, your accountant or your attorney will properly advise you when to take the plunge. However, sometimes these professionals will encourage the election before you are ready so they can charge you for their services. The likely detriments resulting from an early election relate to paying higher tax preparation fees, payroll fees (since you now must pay yourself a salary), and various state maintenance fees. The less likely drawbacks include prematurely locking the company into an entity with excessive restrictions on ownership and distribution of profits. S corporations cannot have more than one hundred shareholders and must distribute profits strictly on the percentage of ownership shares. Small businesses are more exposed to the risks of higher fees than ownership restrictions, but it is important to keep them in mind.
Becoming an S corp is straightforward, as is reverting an S corp to a sole proprietorship, partnership, or regular corporation. Once the revocation happens, companies are ineligible to reapply for S corp status for five years. Therefore, it is important to know when a business could profit from becoming an S corporation or when it is not prudent to do so. Only you, as the business owner, can make that call.
If you would like further advice on when to become an S corporation, please email us at loans@bankable.org. We would love to help.
Written by: Danielle Deal CPA
If you would like some resources on S corporations, check out the following links:
