by Gary W. Smith

Choosing the right entity for your business isn’t easy.  In our first post, we listed questions you need to consider and the potential tax structures available to your business.  In this post, we will look at the third structure, S corporations.

First, just like C corporations, the term “S corporation” refers to how the entity is taxed for income tax purposes.  The entity is just a corporation formed under state law.

The biggest difference between a C corporation and an S corporation is that the income tax liability for an S corporation “flows through” to the owners.  Rather than the C corporation paying the tax, the owners of the S corporation pay the tax.

Why would you do that?  There is one reason—you will pay less income tax.

How do you pay less tax?  Here are some of the potential ways

  • You are only paying one level of tax to get cash in the owners’ pockets. The S corporation doesn’t pay tax on its income with the owner then paying tax on the dividends like a C corporation.  Just the owner pays tax on the income from the S corporation.
  • You are able to take distributions of profits as an owner which aren’t subject to payroll taxes
  • The owner can separate capital gains and ordinary income which you can’t do inside the C corporation. This means less tax when you sell the business and transfer assets.

Why doesn’t everyone use an S corporation?  There are three main reasons in my opinion.

First, only human beings and certain trusts can own stock in an S corporation (unless the stock is owned 100% by another S corporation).  This may not work for your ownership group.

Second, profits must be shared based on the percentage of stock owned.  You can’t have two or more classes of stock (except when the only difference is voting rights).  That may not work for the financial terms of the investment being offered to owners.

Third, if you distribute property (other than cash) from the S corporation to its owners, the distribution is deemed to be a sale of the property at fair market value so that tax may be due as a result of the distribution.

An S corporation is typically best used for operating businesses, not entities investing in real estate or other assets for a gain.

We are going to focus on partnerships in our next post.

Please feel free to send me an e-mail at gary.smith@vennlawgroup.com if you have a question about these options.