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Should You Opt for S Corporation Status?
Depending on your situation, you may want to operate your small business as an S corporation. The benefits can be significant.
Background: As opposed to a traditional C corporation, where profits are taxed to the corporation and then taxed again to shareholders when they are paid out as dividends, the profits and losses of an S corporation are passed directly through to shareholders. There is generally no corporate tax on S corporations. Avoiding this "double tax" is often cited as the main advantage S corporations have over C corporations, but it is not the only one.
Here are several other reasons why you might want to choose to go the S corporation route.
Loss write-offs: It is not unusual for a business to incur a loss, or even a series of losses, in its early years of existence. If the business is set up as a C corporation, these losses are pretty much wasted. The tax law allows operating loss carrybacks, but they will not do your corporation any good if there are no profitable years to carry the losses back to. However, with an S corporation, the tax benefit of the loss is passed through to the shareholders. Each shareholder who participates in the business can write off a portion of the loss on his or her personal return.
Family income splitting: Giving shares of S corporation stock to family members in lower tax brackets allows you to reduce the tax on your business profits. A portion of the profits will be taxed directly to the other family members, reducing the overall tax load. You can, of course, also transfer shares of stock in a C corporation to other family members. But this cuts your family tax bill only to the extent that you declare dividends. Result: Then you face double tax again.
Corporate AMT: A C corporation that has a relatively low regular tax bill because of tax breaks or adjustments may have to pay an alternative minimum tax (AMT). This effectively reduces the benefit of the tax breaks or adjustments. S corporations are exempt from the corporate AMT. Instead, the S corporation allocates these breaks and adjustments among its individual shareholders. Since the corporation's tax breaks and adjustments are divided up, it is less likely that anyone will be hit with the AMT for individuals.
Charitable contributions: A C corporation's deduction for charitable gifts cannot exceed 10% of its income. Gifts by an S corporation are deducted on each shareholder's return. And an individual shareholder can claim a charitable deduction for up to 50% of his or her income.
Due to recent tax law changes, it is easier than ever to qualify for S corporation status. Nevertheless, there are certain disadvantages to this type of entity, including restrictions on fringe benefits for employee shareholders. State law may also have an impact, so obtain professional assistance for your situation.