So, you’ve started a small business, and you want to incorporate for business or legal reasons. Before you do, you should know about a business structure that can actually give you significant benefits: S corporations.
By incorporating as an S corporation (or S corp), you can avoid the double taxation that's usually associated with incorporating your business. Plus, you could save enough on self-employment taxes to make up for the additional costs associated with incorporating and have some money left over to invest in other parts of your business.
Sounds like a win-win for you and your small business, right? Read on to see if incorporating as an S corporation is right for you. We’ll be covering the top benefits as well as the advantages and disadvantages of S corps over other business types:
- Tax Advantages
- Health Insurance Tax Savings
- Employee Expense Deduction Under an Accountable Plan
- Retirement Planning
- Advantages and Disadvantages of S Corps
What is an S Corporation?
Before we get into the thick of it, let's go over what an S corporation actually is.
An S corporation is a type of small business corporation. A corporation is a legal entity that is separate from its owners, which means its owners and shareholders aren't held responsible for the finances (including debt) or actions of the business.
Qualifying to become an S Corporation
Only certain entities can elect to become an S corporation, and they must maintain that status throughout the entire tax year to qualify for tax benefits. Here's what you need to qualify as an S corp:
- The business entity must be either a U.S. formed LLC or regular C corporation
- Cannot have more than 100 shareholders
- Must only have one class of stock
- All shareholders must be U.S. resident individuals
- U.S. citizens or legal residents of the U.S.
- Certain trusts and estates may qualify; check with your tax advisor
Benefits of S Corporations
While there are obvious benefits to incorporating any type of business, S corps offer unique and pretty useful benefits that other structures do not. Here are four of the top benefits of becoming an S corp:
1. Tax advantages
Let's talk S corporation taxation. The main benefit of incorporating as an S corporation over being self-employed is the tax savings on self-employment taxes (Social Security and Medicare). For each dollar of profit, it could mean as much as 14.13% in savings when it's time to pay taxes.
An S corp must pay a reasonable salary to any shareholder/employee. While a reasonable salary will reduce profits, any profits that remain after deducting a reasonable salary and other tax deductions are no longer subject to self-employment tax.
After determining what your reasonable salary should be, you can start with regular payroll. Not to brag, but Wave's small business payroll software is a breeze because it helps you pay yourself and your team and generates important reports and documents for you, leaving you prepared for tax season. Plus, it teaches you as you go, so no accounting experience is necessary.
“We were using a million different platforms to do what Wave can do all in one. It just worked. It was so painless. It’s helping me run my business and not worry about payroll." - Will Perkins, Continue
2. Health Insurance Tax Savings
Most S corps shareholders/employees should be able to save additional payroll tax by having their S corp pay for their family health insurance coverage. As long as it is included as part of their wages, and their spouse is not eligible for coverage under a subsidized health insurance plan, this is another great benefit of incorporating.
While the premiums (the amount to be paid for the insurance policy) included as wages are taxable personally and subject to income tax withholding (this is when the employer withholds a set amount of income from an employee's paycheck that gets directly paid to the government), the amount paid is deductible (as wages expensed by the S corp), and the premiums are exempt from employment taxes (FUTA, Social Security or Medicare). This means that the premium is considered self-employed health insurance and therefore is deductible on a shareholder or employee’s personal income tax return as well. TL;DR: this all results in income tax savings.
3. Employee Expense Deduction Under an Accountable Plan
Under current tax laws, employees can no longer deduct out-of-pocket (when you use your own money to pay for something) business expenses on their personal returns. As a result, the only option for employees to not be out-of-pocket is to get reimbursed by the corporation.
For an S corporation with shareholder employees, out-of-pocket business expenses can be paid by the employee and reimbursed by the S corp. These can include home office rent, car mileage or transportation costs, cell phone and Internet plans, and more.
To do this, the S corporation must set up an Accountable Plan, which is used for reimbursing workers for business expenses that are not counted as income. An Accountable Plan requires expenses to be substantiated for business purposes, where excess payments should be returned within a reasonable time period.
Remember that the personal use portion of these expenses (i.e. personal mileage, personal cell phone calls and personal use of the Internet) must not be reimbursed by the S corporation, and submitting incorrect expenses could be a red flag with the IRS. When creating an Accountable Plan, it can be helpful to keep a shortlist of popular deductions and expenses for you and your team.
4. Retirement Planning
With an SEP IRA (Simplified Employee Pension Individual Retirement Arrangement), an S corporation can provide retirement contributions up to 25% of an employee’s compensation, or $61,000 (whichever is less) in 2022. Contributions to an SEP IRA must be made on or before the employee’s tax return due date.
An S corp, owned by either a single individual or a married couple, and without any other employees, can set up a Solo 401(k) plan and defer up to $20,500 of income (per individual) from taxes in 2022. As an employee, the amount of contribution made to a Solo 401(k) will reduce the employer’s SEP IRA contribution limit.
Incorporating as an S corporation lets you defer paying taxes, but you will still need to pay them eventually. Any income will be taxed when it is taken out of the contribution plan at your gradual tax rates (tax rates depend on the year of the withdrawal, and can sometimes vary). There are penalties for withdrawing before age 59.5 (usually 10%).
If you decide to contribute to a retirement plan, keep in mind that the time of year you contribute can affect tax filing. Make sure to contribute before your tax filing deadline to make the most of your contributions.
5. Advantages and Disadvantages of S Corps Over Other Business Types
Before we start comparing the benefits to incorporating as an S corporation over other forms of business, let's go over some definitions.
A sole proprietorship is an unincorporated business that is owned by one person; the owner is not separate from the business. An LLC/partnership is a business structure in the U.S. that protects its owners from personal responsibility for any lawsuits or debts incurred by the business. And, finally, a C corporation is a legal structure in which the owners are taxed separately from the corporation.
S corporation advantages over sole proprietorships
- An S corp will help protect your personal assets
- S corps have an unlimited life, which means they exist after the passing of the owner
- It’s easier to transfer ownership of the business as an S corp
- An S corp can help you save on self-employment taxes
S corporation advantages over LLC/partnerships
- LLC members/partners cannot be employees
- S corp profits are not subject to self-employment taxes
- S corps don't expire, while LLCs can
- You only need one person is order to form an S corporation
- S corps have more financing options, so there is more potential to scale
S corporation advantages over C corporation
- Flow-through taxation: S corps avoid corporate income tax and most federal taxes on earnings
- S corps are easier to start and sustain than C corporations
It's also important to consider the disadvantages of S corporations to see if becoming one is right for you.
Sole proprietorship advantages over S corporations
- Pass-Through Taxation: sole proprietors pay federal income tax and self-employment tax at each owner’s personal income tax rate, rather than the business's
- There's no paperwork needed to become a sole proprietorship
LLC/partnership advantages over S corporations
- LLCs offer more flexibility than S corps, especially when it comes to IRS and government regulations and allocating their profits and losses
- LLCs are generally easier and cheaper to establish
- An S corp must have specifically appointed members, like board directors, and regular board meetings
C corporation advantages over S corporations
- There are more restrictions on S corps, so C corporations sometimes have more room to grow. However, it is easy to switch from an S corp to a C corporation.
Moving forward with business incorporation and the election
If you have decided to structure your business as an S corporation, and if you are currently operating as a sole proprietor, it is best to seek a professional to assist with the formation of your LLC or corporation. If your business has other partners, shareholders, or members you will need to get them to agree to your decision.
After registering your business, be that an LLC or corporation, make sure to file the S corp election with the IRS within two months and 15 days from the incorporation or formation date. If you have passed that date, you may still qualify for late election approval.
As you look at incorporation and an S corp election, you should weigh the tax benefits and potential administrative costs of the different structures. We see a lot of business owners not knowing their options and the associated benefits, so we want to make sure you are informed.
Wave Advisors can help with your incorporation journey. The Wave team can support your S corporation planning by helping you understand if incorporating makes the most sense for your business from a tax perspective. They can also walk you through processes and forms, like election Form 2553, to help you prepare the strongest possible application, and file easily with the IRS.
Once an S corp election is approved by the IRS, business owners can start using Wave Payroll as an ongoing feature to properly manage their finances and truly reap all of the benefits that come along with being an S corporation.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.