Benefits of S Corp
There are generally three types of business forms from which to choose when starting a new company. The sole proprietorship gives unlimited liability to its owner in which the personal wealth of the owner is in jeopardy if the business runs into trouble. Money from a sole proprietorship is simply taxed as income on the owner’s personal income tax. A partnership is similar to a sole proprietorship except multiple owners have a claim to the organization. General partnerships also carry unlimited liability to the owners even if just one of the owners acts in the interests of the others. Unfortunately, partnerships are often dissolved when one of the owners dies. This impermanency is one reason why a corporation may be a better choice in some situations.
The corporation enjoys four main benefits over the other organization forms. These benefits include limited liability for the owners, permanency, the ability to transfer ownership to other parties, and access to capital stemming from the permanency of the firm. However, sometimes a normal corporation is too complicated for a small business and yet a partnership is too inflexible to meet the needs of the organization. The S Corporation, which conceptually lies between a partnership and a corporation, can be the solution to this problem.
Under the U.S. Code Title 26 Subtitle A Chapter 1 Subchapter S Part 1 § 1361, an S corporation is defined as:
For purposes of this title, the term “S corporation" means, with respect to any taxable year, a small business corporation for which an election under section 1362 (a) is in effect for such year.
Section 1362 of the code states that a small business corporation may elect to become an S corporation if all shareholders consent to the election. Like a corporation, owners of an S corporation enjoy limited liability from creditors so that the personal wealth of the owners is not in jeopardy should the company default on an obligation. However unlike a corporation, income from operations is not taxed at the corporation level but is taxed as personal income on the owners’ own personal income tax. One of the disadvantages of a corporation is that income is taxed twice. Since the corporation is considered an entity like a person, its income is taxed at the corporate level and then the income of the owners is taxed on their personal income taxes. An S corporation avoids taxation at the corporate level just like a general partnership.
So with all these benefits, why would you ever not choose S Corporation status?
Why Wouldn’t You Choose S Corporation?
The question remains, however, why would a corporation elect for double taxation when it can enjoy the benefits of S corporation status? The answer lies in the necessary qualifications to operate as an S corporation. Section 1361 (b) (1) states that to be eligible for S corporation status, the corporation must not have more than one-hundred shareholders, have as a shareholder a person who is not an individual, have a nonresident alien as a shareholder, and have more than one class of stock.
These qualifying attributes clearly show that S corporation status is reserved for small businesses that need some of the advantages of a corporation but wish to remain small. Corporations normally have thousands if not millions of shareholders. By keeping the number of shareholders to a maximum of one-hundred, the S corporation is likened to a very large partnership. Also note that the type of stock must be limited to one kind. Corporations often have what is referred to as preferred stock which lies somewhere between ownership associated with common stock and a claim to debt like a bond or note. S corporations are, therefore, limited to the means by which they may bring capital into the organization.
The S corporation can be thought of as a large partnership that enjoys some benefits of the general partnership with some benefits of a normal corporation. In the eyes of the government, S corporations are separate entities like a corporation meaning they may own property, enter into contracts, and borrow money all the while giving only limited liability to their owners. The structure of an S corporation is more complicated than a partnership because certain rules and regulations about its governance must be followed. However, in some situation, the benefits of S corporation status far outweigh the limitations of a partnership.