Starting a business with the goal of “taking it public” or attracting institutional investors is the goal of many entrepreneurs.
Bootstrapping a business and trying to grow it as large as possible, with the goal of either staying on as the founder/CEO or eventually selling to another business, is another common goal of entrepreneurs.
A third objective for starting a business is aiming to sustain a particular level of income with as few employees as possible. These entrepreneurs don’t have the ambition to grow as big as possible and eventually sell. Their goal is to build a business to a specific income level that can sustain the founder’s preferred lifestyle. This is where the term “lifestyle business” comes from.
For many of these so-called lifestyle businesses, the S corporation entity is a perfect choice for business entity. You may already be asking yourself how are S corporations both similar and different to C corporations? What makes an S corporation a good fit for a lifestyle business?
In our first article examining different business entities, we looked in detail at the C corporation. In this article we turn our attention to the C corporation’s cousin, the S corporation, and why lifestyle businesses are a perfect match for this type of business entity.
Where does an S corporation come from?
Both C corporations and S corporations are born the same way – by filing Articles of Incorporation with the state in which the business will be located. (A business organized as a limited liability company can also elect to be treated as an S corporation for tax purposes.)
(Remember that the terms “C corporation” and “S corporation” are tax terms, not legal terms.)
Once a business has incorporated, it can choose to be taxed either as a C corporation or S corporation.
If the business wants to be taxed as a C corporation, nothing further needs to be done. The default tax entity for an incorporated business is the C corporation.
If the business wants to be taxed as an S corporation, Form 2553 (“Election by a Small Business Corporation”) needs to be filled out and submitted to the IRS. Filling out Form 2553 and submitting it to the IRS is also referred to as “making an S-election.”
As with any other IRS form, there is a deadline to submit Form 2553. The general deadline to submit an S-election is the due date for the S corporation’s tax return. For an S corporation with a December 31 year end, the deadline to submit both the tax return and S-election is March 15th.
A simple structure for simple businesses
If you wanted to start a business in the first half of the 20th century, you had two options:
- Form a C corporation to take advantage of liability protection but be subjected to two layers of federal tax at the corporate and individual level, or…
- Choose to be a sole proprietorship or partnership, enjoy the benefit of a single layer of taxation, but forgo the liability protection afforded C corporations.
Neither of these choices were favorable for small and family-owned businesses. In 1946, the Department of Treasury suggested a third choice of entity, one that combined the liability protection of a C corporation with the single layer of taxation from sole proprietorships or partnerships.
U.S. taxpayers waited another 12 years before this suggestion of a hybrid entity actually came to fruition. In 1958, Congress and President Dwight Eisenhower created Subchapter S of the tax code. Subchapter S provided the benefit of limited liability that C corporations have while maintaining the tax benefits of sole proprietorships and partnerships.
The S corporation was created to address the specific problems faced by small businesses looking to enter markets dominated and controlled by large corporations.
There were four trade-offs, however, to using the new S corporation entity structure:
- Must be a domestic business
- Have a limitation on the number of shareholders it is allowed to have
- Have limitations on who could be a shareholder
- Can only have one class of stock
For many small businesses in the mid-20th century, these limitations were often never an issue.
Former Internal Revenue Service commissioner Don Alexander described the S corporation as “a simple structure for simple people” and simple businesses during Congressional testimony in 2006.
Let’s take a closer look at each one of these limitations and how they affect businesses 60 years after the S corporation was written into law.
S corporations: Must be a domestic business
When grappling with how to best help small businesses in the United States, the Internal Revenue Service, Congress and President Eisenhower recognized the need for a business entity that combined the limited liability of a C corporation and the simplicity of a sole proprietorship or partnership.
Our esteemed politicians also understood that a new, hybrid business entity could lead to all kinds of unintended consequences. (That’s how the U.S. tax code works, right? Congress passes a law, then CPAs and attorneys figure out different ways of legally working around the new law.)
To make sure that this new, hybrid entity would benefit only U.S. small businesses, the first limitation of an S corporation is that it must be a domestic business.
S corporations: Limitation on number of shareholders
When S corporations were first created in 1958, the maximum number of shareholders allowed was 10. The number of allowable shareholders slowly increased every few years. The American Jobs Creation Act of 2004 expanded the allowable number of shareholders to its current level of 100.
One of the reasons the number of allowable shareholders kept increasing was to accommodate family businesses that grew over multiple generations to include multiple family members. This problem was also addressed in 2004 when new rules allowed all members of a family (as defined by the tax code) to be treated as a single shareholder.
S corporations: Limitations on who can be a shareholder
Shareholders of an S corporation must be U.S. citizens or residents; non-resident aliens are not permitted to be a shareholder.
Shareholders must also be a natural person; therefore corporations and partnerships are ineligible to be shareholders.
Certain trusts, estates and tax-exempt corporations (including 501(c)(3) corporations) are eligible to be S corporation shareholders.
An S corporation can also be a shareholder in another subsidiary S corporation, if the parent S corporation owns 100% of the stock of the subsidiary corporation. An election is made to treat the subsidiary S corporation as a “qualified subchapter S subsidiary.” Once the election is made, the subsidiary S corporation is not treated as a separate organization for tax purposes.
There have been ongoing discussions about this particular limitation and if changes should be made due to the global nature of today’s economy. When the S corporation was born in 1958, opportunities to be a nonresident alien shareholder were not that common, for example. But in today’s global economy, many businesses have employees as well as owners and investors located in multiple foreign jurisdictions.
While the limitation on who can be an S corporation shareholder will likely never completely go away, stay tuned to see what changes might be made in the future to accommodate the everchanging way that countries around the world conduct business.
S corporations: Can only have one class of stock
The Internal Revenue Service definition of a single class of stock means that all shares of stock outstanding must provide “identical rights to distribution and liquidation proceeds.”
Another way to interpret this definition is all profits and losses are allocated to shareholders proportionately to each shareholder’s interest in the corporation.
These four limitations don’t affect 90% of S corporation businesses
So with these four stipulations on what an S corporation is allowed and not allowed to do, wouldn’t it be a headache to be an S corporation shareholder?
For sure, some businesses would have trouble avoiding these four limitations. But for the vast majority of businesses who elect to be taxed as an S corporation, these limitations rarely get in the way. And the statistics of S corporations back up this theory.
In 1995, there were 2,153,119 S corporation tax returns filed with the Internal Revenue Service. In 2003, the number of S corporations was approaching 3.5 million, an increase of 65% percent.
C corporation tax returns, on the other hand, decreased from 2.6 million in 1986 to 2 million in 2003.
Despite the extra hurdles S corporation shareholders need to jump through, the S corporation was a smashing hit with U.S. small business owners.
Here’s another statistic to consider – Close to 90% of S corporations have 3 or fewer shareholders: In 1995, 52% of S corporations had 1 shareholder; 30% has 2 shareholders; 7.6% had 3; 8.7% had 4 to 10. Only 1.6% of all S corporations had more than 10 shareholders. Average total assets for S corporations were $473,000, while C corporations averaged $10.8 million.
The vast majority of S corporations are truly small businesses run by a small number of shareholders. These businesses never encounter the 100 shareholder limit, have to deal with ineligible shareholders or multiple classes of stock. The S corporation is serving exactly who it was intended to serve: small businesses based in the United States.
Losing S corporation status
The S corporation is the only business entity where you can lose your entity tax status.
And it’s pretty simple to do it.
All a business has to do to lose its S corporation status is violate one of the four restrictions mentioned earlier in this article: 1.) Having more than 100 shareholders; 2.) Having the business be a foreign business; 3.) Having an ineligible person or entity as a shareholder; and 4.) Having more than one class of stock.
Shareholders must be vigilant in a business’s compliance of these limitations, because these limitations can sometimes be inadvertently violated.
Ownership limitations make raising capital difficult
If you’re starting a business with the goal of raising capital or attracting investors at some point in the future, electing to be an S corporation could possibly hinder these efforts.
What happens if you have an angel investor from England who wants to provide your business with several hundred thousand dollars? What about a venture capital firm headquartered in Singapore wanting to invest in your business? You would have to turn down both these potential investors because the angel investor is a foreign alien, while the venture capital firm is a partnership. Both foreign aliens and partnerships are ineligible to be S corporation shareholders.
If you are fortunate enough to find angel investors who live in the U.S., many companies will require a number of different investors. The 100 shareholder limitation can fill up pretty quickly.
How are S corporations taxed?
In 2018, Jill started a dentistry practice. She is the sole owner.
After paying all her business’s expenses, Jill’s practice turned a profit of $100,000. Jill has to pay income taxes on the $100,000 profit on her Form 1040 tax return. If Jill’s income tax rate was 15%, she would have to pay $15,000 in income taxes.
If Jill’s business was a sole proprietorship, she would also have to pay self-employment taxes of 15.3% on the $100,000 profit, or $15,300. Jill’s total tax bill as a sole proprietor would be $15,000 of income taxes + $15,300 in self-employment taxes = $30,300.
If Jill’s business were an S corporation, she wouldn’t have to pay ANY self-employment taxes on the $100,000 profit. Jill would only have to pay income taxes on the $100,000, or $15,000.
Sounds like no contest, correct? S corporation wins? Why would you willingly choose to pay $30,300 in income and self-employment taxes if your business is a sole proprietorship vs. only $15,000 in income taxes if your business is an S corporation?
There must be a catch, right? Can S corporations really pay no self-employment taxes?
Shareholders must report reasonable compensation
You bet there’s a catch. It’s true that Jill doesn’t have to pay self-employment taxes on the business’s $100,000 profit. The IRS, however, forces Jill to take a “reasonable salary” from the business.
In our example, Jill would be forced (by the IRS) to take a salary of approximately $70,000. This would decrease the business’s profit from $100,000 to $30,000. Jill would have to pay Medicare taxes of 1.45% ($1,015) and Social Security taxes of 6.2% ($4,340) on her $70,000 salary. The business would also be required to match Jill’s Medicare and Social Security payments.
Total payroll taxes would equal $1,015 (Jill’s Medicare payment) + $1,015 (the business’s Medicare payment match) + $4,340 (Jill’s Social Security payment) + $4,340 (the business’s Social Security payment match) = $10,710.
So in our example if Jill’s business was an S corporation, Jill would pay $15,000 in income taxes + $10,710 in self-employment taxes (Social Security and Medicare) = $25,710.
Rule of thumb – If taxable income is >30k, you may see advantages of an S corporation
When Jill’s business turns a profit of $100,000, we showed how her tax liability would be $30,300 as a sole proprietor (or partnership) or $25,710 as an S corporation. That’s a difference of $4,590.
As a general rule of thumb, if your business is generating taxable profits of at least $30,000, it might be worth talking to a CPA to see if converting your business to an S corporation makes sense and can save you money.
S corporations are a great option for lifestyle businesses
President Dwight Eisenhower and Congress were successful in creating a hybrid entity that helped small business owners in the U.S.
With most featuring three or fewer shareholders, very few S corporations have to worry about the hurdles surrounding who can be a shareholder, number of shareholders, being based in the U.S. and having only one class of stock.
That’s why the S corporation is a perfect fit for these lifestyle businesses whose owner has no grand ambition to grow the business as large as possible and attract as many investors as possible.
If you think you might have a business that will want to attract investors in the near future or have foreign operations, then a C corporation or LLC will be a better choice.
Now that we’ve examined C corporations and S corporations, we turn our attention next to general partnerships. Which businesses should organize as a general partnership? How do they compare with C corporations and S corporations?