S vs C Corporations
Which Option is Right
For Your Venture?
Whether you're setting up a new company or you've been in business for
years, you need to evaluate which legal structure is best for your
enterprise. No one option is best for every type of operation. The
right choice depends on several factors including the number of owners,
taxes and your business goals.
Dividend distributions avoid payroll taxes so it's generally
advantageous to take as much income as possible in the form of
dividends, rather than compensation. But the law requires you to take a
In 2007, you pay 7.65 percent for both
the employee and employer share of Social Security and Medicare taxes.
Social Security must be paid on the first $97,500 in salary. (In 2006,
7.65 percent of $94,200.)
careful if you go for higher dividends and a lower salary. Keep good
records to justify your compensation. The IRS will be looking for
factors such as what duties you perform for the company, whether you're
an officer, how profitable the business is, what you would pay someone
else to do your job and what the standards are in your industry.
If the IRS reclassifies your dividends
into salary, it can result in a substantial tax bill, as well as hefty
penalties and interest.
These concerns lead many business owners to organize as S corps. The
legal structure is identical to a C corporation but S status provides
an escape from double taxation.
choosing a business structure can be a complicated process with
long-range consequences, you should consult your tax adviser. Here are
some of the pros and cons of S corps:
Like any corporate
organization, an S corp allows you and any co-owners to restrict
personal liability. If, for example, your company is unable to pay its
debts, the business assets would be open to creditors but your personal
belongings would be off limits. However, you don’t have total
protection from liability — if your company
is in the business of offering advice, for example, you won't be
protected if the advice you personally offer is wrong.
An S corporation allows you to avoid two-tiered taxation —
that is, paying corporate taxes and then paying personal taxes on the
same income. An S corp pays no federal taxes. Earnings — and
losses — are passed through to the owner. And because income
is taxed to the owner, you can avoid problems arising from the
corporate alternative minimum tax. An S corporation must, however,
still file a tax return, and some states impose taxes.
If you think you might have operating losses in the first couple of
years in business, an S corp may be a wise choice. Let's say you invest
$100,000 in your venture and wind up with a loss of $25,000.
The deficit is passed through to you and any other owners —
on a pro rata basis — so you can take the loss against other
income on your personal tax returns. However, you cannot take
current-year losses that exceed your adjusted basis in the company.
A corporation's S status can be terminated either voluntarily or
involuntarily. Voluntary termination requires a vote of shareholders
owning more than 50 percent of the company’s total
outstanding voting shares. Involuntary termination can result from not
following the restrictions placed on S corps (See box below).
Pro rata taxable
income and dividend distributions are free of FICA taxes (Medicare and
Social Security). Company contributions to a retirement plan on behalf
of a shareholder-employee are also generally not subject to FICA taxes.
In a family business, you may be able to get some tax advantages by
shifting the owners’ income to other family members by making
them employees or shareholders or both.
Warning: The prospect of major employment
tax savings may tempt you to cut your compensation and take large
dividend distributions instead of salary. But the IRS keeps a keen eye
on “reasonable compensation.” If the tax agency
finds that compensation is inadequate, it can recharacterize your
dividend distributions as wages, which means you become liable for
unpaid employment taxes, penalties, and interest. (See box above.)
If your company owns any
assets that have appreciated, they cannot be distributed to you and
your co-owners without generating a tax bill.
Taking money or assets out of an S corporation can be an administrative
headache. For example, the withdrawal must be characterized for tax
purposes as compensation, a dividend, a loan, or
other payment. Compensation means payroll taxes are due and W-2 forms
and payroll tax returns must be filed. A loan requires a loan document.
S Status Restrictions
The corporation must be domestic.
2. There must be no more than
3. The shareholders must be
U.S. citizens, resident aliens, estates, certain types of trusts or
It can be difficult to raise cash through a stock offering because an S
corporation can issue only one class of stock, which must have
identical rights regarding dividends and the distribution of company
assets if the business is liquidated.
Ultimately, an S corp provides a good option for a small
enterprise that would otherwise be significantly taxed under the
traditional corporate model. When selecting or considering a new legal
structure, business owners should always review their options with
their tax lawyer. Call Ronald
J. Cappuccio, J.D., LL.M.(Tax) at (856) 665-2121.
are the best form of legal entity for most small businesses. For more information...