If you’ve been self-employed for a while and have begun earning a decent income, it might be time to consider whether or not you would benefit from converting your business to an S-corporation. You might be a bit intimidated because it sounds complicated and expensive, but don’t let that discourage you from checking out the benefits as well as the drawbacks of the process. Then, once you’re fully informed, you can make the decision that is right for your company.

What do I gain from electing to be treated as an S Corporation by the IRS?

Liability protection

First of all, corporation status will protect your personal assets from any business liability. If you are currently running your business as a sole proprietorship, you are at risk of having your personal assets claimed for business liabilities, including debts or lawsuits. Incorporation will fully separate your personal and business assets and liabilities. If you’re already operating as an LLC, however, this is not a concern, because the LLC (Limited Liability Company) already eliminates the personal liability issue.

Double taxation avoidance

In an S-corporation, the revenue is passed through the “entity” stage tax-free, and is only taxed at the level of the employees and owners. This is unlike a regular C-corporation, where the income is taxed at the corporate level and then again as part of the owners’ (shareholders) and employees’ personal income tax filings.

Allow outside investment

An S-corporation is permitted up to 100 investors/shareholders. This means that you can trade equity in your company for outside investment that can be used to pursue investment opportunities that you might not have been able to manage on your own.

Cash-based accounting is still an option

If you run a service-based business, and carry no inventory for resale, you can elect to file your taxes using a cash basis, which is simpler than an accrual basis.

Tax savings for owners

We may be guilty of burying the lede here, but the best reason to make the switch is for potential tax savings. This is perhaps the best reason to elect S-corporation status for your business. Under an LLC, because all the income is passed through to your personal income tax return as business income, you will owe payroll taxes (social security and medicare) on all of the income. Under the accounting rules that apply to an S-corporation, however, you can pay yourself a “reasonable” salary, and then take any remainder of the money that you want to withdraw as a distribution, which is not subject to payroll taxes. Distributions are also taxed at a much lower rate than ordinary income, so there are double savings in paying yourself this way.

Potential drawbacks of incorporating as a S Corporation

Complicated tax rules

While the regulations are nowhere near as complex as those for a regular C-corporation, there are certain procedures to be followed. It’s probably best to hire someone who can both setup and administer the annual requirements for your company, rather than to try to do it yourself. In that case, of course, there is also the expense of paying someone to file and maintain the paperwork for you.

Extra accounting work

The formation of an S-corporation requires additional paperwork in terms of tax filings, which leads to more expense. And since the owner is now also considered an employee, payroll taxes must be reported and filed quarterly, even if the owner is the only employee.

Shareholder restrictions

Unlike a C-corporation, only individuals can become shareholders of an S-corporation, and they must all be U.S. citizens or permanent residents. Furthermore, only one class of stock may be issued. So there cannot be any trusts or partnerships with a stake in your S-corporation, and shareholders must get a vote equal to the precentage of shares they hold. (Two exceptions to these rules: families can often be counted as a single owner, and non-voting stock can be issued.)

Shareholder income

Regardless of whether or not shareholders actually withdraw any compensation from the company, they will be taxed on their share of the total income. In a C-corporation, shareholders are only taxed on the distributions that they actually receive, not on their share of the company’s entire income.

Owner salary

Often in a small, struggling company with cash-flow issues, the owner will forego his own salary in order to be able to pay his employees. However, in an S-corporation set-up, the owner must pay himself a reasonable salary as an employee. And by reasonable, the IRS means comparable to industry norms, not an incredibly low wage to simply adhere to the letter of the law without following its spirit.

Passive income restrictions

S-corporations cannot be treated as investment trusts. No more than 25% of total company gross receipts can be derived from passive activities, such as real estate investing. The bulk of the income in an S-corporation must come from active participation in the production of goods or services for customers.

In order to set up an S-corporation, you must first charter your business as a corporation in the state where your headquarters is based. Once that is completed, you must elect S-corporation status by filing Form 2553 Election by A Small Business Corporation with the IRS, which all existing shareholders must sign. This form must be filed within two months and 15 days after the beginning of the tax year for which you want the election to be effective, or at any time before the tax year begins.

There are also a number of ongoing requirements that must be maintained during the existence of your S-corporation, such as annual meetings and the compilation of meeting minutes, as well as written authorization from a majority of shareholders before certain actions can be taken. Many of the requirements are exactly the same for both a C-corporation and an S-corporation. While it is possible to accomplish these yourself, it is probably wise to consult with someone who is an expert in the legal aspects.

Depending on the size of your company and the amount of your income, it may be well worth the expense to set up and maintain an S-corporation instead of an LLC. You can potentially save tens of thousands in taxes, but it is something that you will want an expert to handle, so be sure to talk to someone experienced in setting up these entities.