When you form a business, you need to consider which entity type you want to use. This can have significant tax and organizational implications. One option is a subchapter S corporation. This special type of corporation has some benefits over a C corporation but also some special restrictions. Below is some information to help you determine if this is the right entity type for your tech business.
What Is an S Corporation?
Business organizational types fall into two main categories: independent entities and proprietorships. Corporations, limited liability companies and a few other entity types are independent of their owners. That means that they exist as their own separate entities from a tax and legal perspective. Conversely, sole proprietorships and partnerships are not independent of their owners.
An S corporation falls into the former category. Like a C corporation, it is an independent, incorporated entity that exists completely separately from the shareholders that own it.
However, an S corporation is intended for small and privately owned businesses. It has different tax characteristics than a more typical C corporation.
What Are the Benefits of an S Corporation?
A C corporation pays its own taxes on profits. If it distributes dividends or the shareholders otherwise earn money, they are taxed separately. This can create a situation in which the same profits from the C corporation are being taxed twice. Obviously, this is not a good thing for small businesses that exist to earn a living for their owners.
A subchapter S corporation is not double taxed. Instead, it passes its tax obligations through to the owners. Therefore, the shareholders have to declare any profits on their tax filings and pay taxes on it. This is essentially like how a partnership would pay its taxes. Although the S corporation is a separate entity, it is taxed as if it were an extension of its owners.
However, unlike a partnership, an S corporation can legally own assets and is separate from its owners. Therefore, the owner's liability is limited to their investment in the company. If your S corporation business closes, you aren’t personally liable for its debts beyond what you have already invested. This can be very helpful for protecting assets.
Transferring ownership of an S corporation is also much easier. You own shares in your corporation and can sell them, issue new shares and otherwise manage it however you see fit.Additionally, the steps for starting an S corp. are relatively simple. It is more complex than creating a partnership but simpler than a C corporation.
What Are the Drawbacks of Starting an S Corporation?
Although an S corporation is a great choice in many cases, it has some restrictions that make it less than ideal in certain cases. One of the main drawbacks compared to an LLC or partnership is that if the owners work for the business, they are employees and must be paid. They cannot work for free. This is less ideal for a new startup that may not have a lot of capital right away.Additionally, an S corporation may only have 100 shareholders and they must be U.S. citizens or residents. Furthermore, the entity can only issue common stock. This means that there cannot be special classes of preferred stock for investors, for example.
Is It the Right Choice?
Overall, an S corporation can confer many benefits for a tech business. It is its own business entity and has special legal protections. This can be very beneficial for many owners. It also is not subject to double taxation.
However, it also is restrictive, especially for new businesses without a lot of capital. Think carefully about whether you want to create an S corporation or not.
Making the right choice for your entity type can have many tax and legal benefits. The right choice for one business may not be the same for another. Consider getting expert help when creating your business.