What is an S Corp?

An S Corporation is a Flow-Through Business Entity

S corporations are a form of flow-through business entity. Unlike the partnership(another flow-through entity) which has to have at least two partners, one person can be in control of an S corporation. So, you can be the sole shareholder and hold all corporate offices if you like. I think the S corporation combines the best of being a sole proprietorship and a regular C corporation. You have the limited liability aspect of incorporation combined with the control over operations like a sole proprietorship.

S Corporation Formation

Being an S corporation is only a tax designation. Just like a C corporation, you’ll have to file articles of incorporation with the Secretary of State where the corporation is located. And, you stake ownership rights to the corporation by purchasing shares of its stock. The number of shares of stock sold determines ownership percentage. If you purchase the only share of stock issued, you are the 100 percent shareholder, totally in control of the corporation and all decision making.

You have to apply for an employer identification number for your S corporation from the Internal Revenue Service using Form SS-4. After you get the employer identification number you have to fill out another IRS form to elect S corporation tax treatment. Make this election on Form 2553. All the shareholders have to agree to the election and sign the form. This usually isn’t an issue as most of the arts and crafts business S corporations I see have one or two shareholders. If there’re two, the second one is normally a spouse.

S Corporation Liability

Like the C corporation, an S corporation will enjoy the aspect of limited liability. With very few exceptions, you as the shareholder or officer of the S corporation are not personally responsible for any actions taken against the business.

A couple of notable exceptions are the trust fund portion of the payroll taxes and sales tax you collect from customers. If you don't timely remit your payroll taxes or sales tax liability, the fed or state government can come after you personally for collection.

In case you’re not familiar with the term trust fund being used this way, the trust fund portion of payroll taxes is the part withheld from the employee’s check – the part that makes up most of the difference between gross and net wages: federal withholding tax, FICA and Medicare.

S Corporation Taxation

An S corporation filed federal form 1120S. This is an informational return only. By that, I mean that the income and expense figures for the S corporation are reported on the tax form, but the bottom line is divvied up between the shareholders and taxed on their Form 1040 at their individual tax rate. If you’re a husband and wife filing a joint return, you’re considered one person in the eyes of the IRS so all the S corporation income or loss will be lumped together with all your other 1040 items.

Wondering what happens if a husband and wife are both shareholders but they file separate returns? Each spouse’s portion of the S corporation income or loss is reported separately on the individual 1040s.

And woo-hoo, unlike a partnership, the ordinary income and loss that flows from the S corporation is not subject to self-employment. This is one of the major reasons I like S corporations better than partnerships.

Here are two other important aspects of the S corporation:

1. You can only deduct S corporations up to the amount of basis you hold in the S corporation
2. Under certain circumstances, shareholders can take non-taxable distributions called return of capital.

Brief Tutorial on Basis

These things increase your basis:

• S corporation income
• Capital gains
• Other income

These things decrease your basis:

• S corporation loss
• Capital losses
• Other expenses
• Distributions you make to yourself

Getting Paid by The S Corp

You’ll give yourself a regular paycheck and get a W-2 at the end of the year just like you did at any of your other jobs working for someone else. One caveat however: it’s tempting to not give yourself a paycheck since distributions from the S corporations can be tax-free or at the very most only subject to federal withholding tax (paychecks are subject to FICA too).

Don’t be tempted. This is a huge issue with the IRS and has been for many years. Make sure you pay yourself reasonable wages. What’s a good guideline for reasonable? Well, think about what you would have to pay another person to do the same job. And, I’m talking about your Mom who would do it for free because she loves you. If you had to place an ad to hire an unrelated employee, what would be a normal hourly wage or salary for the job?

The only way you don’t have to worry about reasonable compensation is if you don’t actually work in the business or the business is losing money and you have make loans to the business to keep the doors open.

Five S Corporation Disadvantages

1. You are taxed on the S corporation income regardless if you took a distribution or not.
2. Mastering how to prepare a paycheck and make the payroll tax deposits can be a pain. Once you get the hang of it, it really isn’t that big of a deal to write payroll checks, make payroll tax deposits and do all the necessary reporting. If you don’t want to do it yourself, it’s not all that expensive to hire a payroll service to do it for you.
3. Some employee benefits such as health insurance are handled differently than other employees if you are a more than 2% shareholder in the S corporation.
4. It’s important to keep track of your basis in the S-Corporation so you know when you’ve hit your limit for the tax-free distributions.
5. Also, I really feel the tax return preparation is best left to an accountant or tax return preparer, so you’ll have that additional expense.