Selecting an entity type for your new business venture can feel overwhelming. From an LLC to a C-Corporation or S-Corporation, the options all present their share of pros and cons, risks and benefits.
One entity type that has risen in popularity among small and medium-sized businesses is the S-Corporation – a twist on the traditional C-Corporation. S-corporations are entities that pass corporate income, losses, deductions, and credits to their shareholders for federal tax purposes.
The shareholders within an S-Corporation report their income and losses on their individual tax returns and are assessed tax at their separate rates. This enables S-corporations to avoid double taxation, to which typical corporations are subject.
As such, many business owners choose S-Corporations over C-Corporations for these massive tax savings. Many start as an LLC, then reorganize as an S-Corporation to gain some additional administrative and tax benefits.
Here, we will break down some of the specifics of the S-Corporation: what it is, how to qualify, and some pros and cons.
How Do You Qualify as an S-Corporation?
According to the IRS, to qualify for S corporation status, an organization must meet the following requirements:
- It must be a domestic corporation.
- It must have only allowable shareholders, which:
- Can be individuals, certain trusts, and estates, and
- May not be partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
To become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation, which is available on the IRS website. This document must be signed by all the organization’s shareholders.
In North Carolina, S-Corporations are taxed under Subchapter S in the Internal Revenue Code.
North Carolina S-Corporations
An S-Corporation is considered separate from the organization’s owners and stockholders. Under North Carolina law, there is no organizational or administrative difference between an S-Corporation and a C-Corporation. An S-Corporation is simply a designation for tax purposes. Those seeking limited liability and a more formal corporate structure can benefit from organizing as an S-Corporation.
A few practical differences apply:
- A C-Corporation must declare profits and losses and pays taxes on profits. Shareholders also pay income tax on what the corporation pays them. This is known as “double taxation.”
- An S-Corporation files a K-1 tax return but doesn’t pay income tax. Shareholders declare their share of the profits on their individual tax returns.
However, there are also several administrative similarities:
- Both types of entities require filing of articles of incorporation or a certification of incorporation.
- Shareholders comprise and are owners of both types of corporations, and are charged with making all management decisions.
- The organizations provide liability protection for their shareholders.
S-Corporation Designation Pros and Cons
Before you decide how to organize your business, it is vital to consult an experienced attorney who can help you determine which designation is best for your purposes. However, in general, there are a few pros and cons to the S-Corporation designation.
- The corporation is an entity separate from its shareholders, so it will continue beyond the incapacity or death of one or more of the shareholders.
- The setup makes it simple to issue fractional stock ownership shares.
- The purchase, sale, and gifting of stock make it possible to transfer ownership without disturbing the entity’s ability to conduct business.
- The requirement to separate the corporation’s finances and records from its stockholders’ reduces the risk of unrecognized equity distributions.
- With a few exceptions, the organization pays no income taxes, and corporate profit and loss are not passed to the shareholders.
- It is simple to run an S-Corporation from an administrative and tax perspective.
- Annual stockholder meetings open the door for continued communication and collaboration internally.
- S-Corporations tend to have good access to credit and loans.
- Earnings are not subject to self-employment tax so long as stockholders receive adequate compensation for their business management efforts.
- Lenders may require personal guarantees from officers to give credit (this then erodes the liability shield).
- Conflicts among stockholders could stunt progress and growth.
- Restrictions on the sale of stock may prevent minority stockholders from recovering a return on their investment.
- Stock ownership can be divided among many different parties who are not as active in managing the business’ day-to-day affairs.
- Corporation-paid stockholder benefits may become too costly.
- Employee benefits are taxable income to stockholder employees with two percent or more stock ownership.
- If the corporation owns appreciated assets and it is subsequently dissolved, it will pay substantial taxes on the appreciation amount.
Contact Our Experienced Business Law Attorneys.
If you find yourself in need of advice on how to organize your business, our attorneys are experienced in helping founders organize as S-Corporations and are here to help.
At Wilson Ratledge, we assist businesses in taking steps to keep them financially secure, while protecting them from legal pitfalls. For assistance growing your business or navigating a deal, contact one of our experienced North Carolina business attorneys today at 919-787-7711 or via our contact form below.