Tax law is extensive, often confusing, and as the OBBBA just proved – ever changing. When it comes to the many taxpayers who currently run their own businesses, or are looking to start, the entity classification options can seem endless and overwhelming. This post breaks down some advantages and disadvantages for business owners to consider before electing S Corp status.
What Is an S Corporation?
In short, S Corporations are pass-through entities that provide many of the benefits of a corporation while avoiding the double taxation that comes with C Corporations. S Corporations themselves do not pay federal taxes; rather, the income (or loss) is passed through to the shareholders. The loss from an S Corporation can often offset a shareholder’s income from other sources. S Corporations can be an ideal option for smaller businesses, but they may not work as well for larger organizations as they must be domestic, do not allow more than 100 shareholders, limit the types of shareholders allowed, and can only have one class of stock, among other restrictionss.
Personal Asset Protection
One of the main advantages of S Corporations, and also for C Corporations and LLCs, is the protection of the owner’s personal assets from any liabilities. Unless there is a personal guarantee on record, owners are not personally obligated to the debts or liabilities of the business. This protection is a distinct difference from a sole proprietorship or general partnership, which considers the owners of a business legally the same as the business itself, meaning personal assets can be vulnerable to business obligations.
Reduced Self-Employment Tax
Business owners often express the desire to, “make my own hours” or “be my own boss.” Self-employment offers these benefits related to flexibility and personal freedom, but it isn’t always as kind when it comes to paying taxes. Another advantage of an S Corporation is the reduced self-employment taxes paid by shareholders. S Corporation shareholders are considered employees of the corporation, drawing reasonable salaries for themselves along with tax-free distributions from their investments. In this case, instead of paying the extra 15.3% of self-employment tax on all S Corporation earnings, the self-employment tax only applies to the shareholder’s salary.
Disadvantages
While S Corporations have substantial advantages and tax benefits, there are also some key disadvantages business owners should keep in mind when considering the election. One important caution, as noted above, is the importance of paying shareholders a reasonable salary. While the temptation can be to forgo a salary completely or greatly reduce the amount to avoid the self-employment tax, the IRS is more than aware of this so-called loophole and is on the lookout for these instances. Underpaying salaries can be a red flag for the IRS and can trigger an audit and amendment of both the S Corporation’s and the shareholders’ returns.
Another key disadvantage of S Corporations is the registration fees and additional fees required by states. While S Corporations do not pay tax on the federal level, many states require at the least a minimum payment. These payments are often required even when the business operates at a loss, and sometimes include additional taxes and fees. Additionally, shareholders are required to file separate S Corporation tax returns on top of their individual returns.
Specific Considerations for Real Estate Companies
S Corporations offer tax advantages that are appealing to many taxpayers, but one industry that may want to go another route is real estate. One issue with real estate in a corporation is the loss limitation. If a real estate investment suffers a substantial loss, S Corporation shareholders can only deduct the loss up to the point of their stock basis, plus any personal loans given to the S Corporation.
On the flip side, a gain on property for an S Corporation can also be a burden to shareholders. Transferring real estate into a S corporation, or any corporation, is considered a sale by the IRS. Therefore, if the real estate has appreciated in value since its original purchase, the gain is subject to a capital gains tax. That means the transferring party will have to pay tax on a gain that has not yet yielded any cash or direct income. One key exception to this rule applies if the transferring party owns 80% or more of the corporation’s stock after the transfer, yet even this exception has downfalls. Transferring real estate into a corporation can cause a headache and major tax consequences for the transferring party, and extracting real estate out of a corporation can have equally detrimental consequences for shareholders.
In an S Corporation, if the corporation sells a property, the gain is passed to the shareholders who will need to pay taxes on the gain. If the property is not directly sold but, instead, is transferred out of the S Corporation to a different entity or individual, this transfer is often treated as a sale by the IRS, causing a tax liability to shareholders who never received direct income or cash from the transfer. These are some of the key reasons why S Corporations are often not a good option for real estate companies.
Final Thoughts
S Corporations offer substantial benefits to many taxpayers running or starting a small business. The election can help shareholders reduce self-employment taxes, protect personal assets, and offer credibility and professionalism to the business. If you want to discuss whether an S Corporation election is right for your business, or if you have any other tax planning questions, please contact your GYF Tax Executive at 412-338-9300.
