If you’re starting your own business, you may be wondering how to set up and structure the business in a way that allows you to stay within the bounds of the law, but also limits the amount of taxes you are required to pay to the IRS. Those who operate their own professional practices (such as doctors, lawyers, dentists, accountants, engineers, etc.) or individual consultants should consider forming an S corporation. The Freeman Lovell team can help you with this endeavor.
Pros of Forming an S-Corp
The biggest advantage of forming an S corporation is that it can save you money on taxes. People who own their own businesses and are not in the employment of others must pay higher FICA taxes (Social Security plus Medicare). That’s because when an employee works for a company, the company pays half of the FICA taxes and the employee pays half. But when you are self-employed, you must pay both portions.
As you can imagine (or may already know well), this can be a sizeable sum. When you form an S Corporation, instead of paying FICA taxes on all the revenue you collect, you only pay them on your salary, which is a number you determine based on the going rate for that job in your particular market.
This move can save you many thousands of dollars. But it isn’t easy to do and there are many caveats, so it’s critical to enlist the help of a professional accountant when you make this decision.
Another tax benefit you can reap from forming an S corporation is that it can function as a pass-through entity. This means you don’t have to pay corporate income tax; instead, you pay taxes as if your revenues are personal income. This is only advantageous in certain situations, however.
Cons of Forming an S-Corp
One of the biggest cons of forming an S corporation is that if you make a mistake, you could end up owing the IRS tens or even hundreds of thousands of dollars.
That’s because operating an S corporation has strict and specific rules.
First, you may only have one class of financial stock. You cannot have preferred shares with different owners receiving varying distributions of profits and losses like you can with a partnership.
Second, your S corporation must be a small business — you cannot have more than 100 owners.
Third, only individuals and not businesses or groups are allowed to invest.
And lastly, no foreign investors are allowed.
This may seem uncomplicated at first glance, but it’s easier than you think to make a mistake. What if you accepted investment money from an individual whom you assumed was an American citizen but was, in fact, not?
A mistake like this can wipe out a year’s worth of income. That’s because if the IRS finds out, they automatically start taxing you as if you are a C corporation. This may not cost you that much, but if you have appreciating or depreciating assets (such as real estate), this switch can get pricey.
Separately, an S corporation structure is not helpful for businesses that need investors, because it’s so restrictive. Thus, entrepreneurs who aim to grow their businesses over time would not do well with an S corporation structure.
The Bottom Line on S-Corps
Based on what you’ve learned here, if you think forming an S corporation would be advantageous to you — whether you are just starting your business or you have been in business for years and want to make the switch — talk to the team at Freeman Lovell.
Forming an S corporation can provide significant tax advantages, but it can also backfire if you aren’t well-versed in all the IRS rules, regulations and technicalities. Moreover, we always recommend that you involve your business lawyer in the decision as well since their advice regarding restructuring your business is invaluable. CPAs and business lawyers each have an important contribution to make the decision to form an S corporation.
Freeman Lovell is dedicated to assisting entrepreneurs and small-business owners with all their tax-related issues, including forming an S corporation.
Call or text us at (385) 217-5611 or send us a message through our Contact Form.