We, the Chicago Accountants, have come to the conclusion that S Corporations are the #1 small business entities for entrepreneurs with ordinary income.
Major reasons why you may form an S-Corporation:
1. Officers and shareholders of an S-Corporation are not personally liable for corporate debts and liabilities, and
2. The S-Corporation’s income distributed to you as a shareholder will not be subject to self-employment tax, however, your wages as an employee will be subject to social security taxes.
It is very important that business owners realize that if they have passive income (such as a rental property), an S-Corporation should generally not be used, but a Limited Liability Company (LLC) or Limited Partnership (LP). The S-Corporation is best suited to manage ordinary income, even if it is a partner in an LLC with other S-Corp partners because the LLC is an operational business.
In order to receive the asset protection of an S-Corporation it is important that the corporation be adequately financed, that various formalities required by your state be observed ( filing articles of incorporation, adopting by-laws, electing a board of directors, and holding organizational meetings), and that the existence of the corporation as a separate entity be maintained.
In regards to the wage and net-income planning, we encourage you to allocate at least 40% of their net-income to wage earnings and the remaining amount can flow out as a dividend or net-income, which are not subject to self employment tax. However, you should obtain a competent professional advice in this regard first. It is important to maintain this procedure through proper payroll planning. Quarterly reports are required.
When it comes to first years losses in any type of business, an S-Corporation is preferable to a C-corporation from a tax standpoint. Shareholders in a C-corporation generally get no tax benefit from such losses.
On the other hand, as S-Corporation shareholders, each of you can deduct your percentage share of these losses on your personal tax return to the extent of your basis in the stock and in any loans you make to the entity. Losses that cannot be deducted because they exceed your basis are carried forward and can be deducted by you when there is sufficient basis.
Once the corporation begins to earn profits, the income will be taxed directly to you whether or not it is distributed. It will be reported on your individual tax return and be aggregated with income from other sources.
Please remember that the S-Corporation could inadvertently lose its S status if either of you transfers stock to an ineligible shareholder such as another corporation, a partnership, or a nonresident alien.
If the S election were terminated, the corporation would become a taxable entity. You would not be able to deduct any losses and earnings could be subject to double taxation–once at the corporate level and again when distributed to you.
This is, of course a short summary of the benefits of an S-Corporation and how to maintain such a company in good standing with the State and IRS. We have incorporated thousands of businesses and have advised many of them to convert into an ‘S’ corp based on tax planning criteria. To find out if an ‘S’ corporation is right for you, please call us at 773-728-1500.