Most small businesses don’t understand the various options that may be available to them when choosing a business entity. Almost everyone has heard of a corporation, partnership, or limited liability company but what does that really mean for your company and why should I choose one over the other. There are many factors that should be considered in choosing an appropriate legal entity including tax treatment of that entity. Things become more complicated when you understand that various entities can choose to be taxed in a manner that doesn’t seem to be consistent with its organizational structure. For example, a sole-proprietor or partnership can choose to be taxed as a corporation.
In choosing what may be best for your family-owned business, there is another alternative available to small businesses called a Small Business Corporation (also known as a Subchapter S Corp or S-Corp). An S-Corp is an election, made by the legal entity, to be treated, for federal tax purposes, differently than its standard selection by allowing its income, losses, deduction, and credits to flow-through the legal entity to its shareholders. The IRS has created a number of requirements in order to qualify and make an S-Corp tax election including the following:
- The entity must be a domestic corporation or other domestic entity
- Have no more than 100 shareholders
- Have only one (1) class of stock
- Only have individual shareholders (exception for certain trust and estates)
- Not be an ineligible company (i.e. certain financial institutions, insurance company, or domestic international sales company)
Once it is determined that the above requirements are met, the legal entity must file, Form 2553, Election by a Small Business Corporation with the IRS no later than 75 days after the beginning of the tax year that the election is to be made or at any time if the election is for a subsequent tax year.
You may ask, with so many options available and dealing the IRS sounds like a hassle, why would someone choose to be taxed as an S-Corp. The use of an S-Corp taxing structure is not appropriate for every situation and important consideration of the impact of such an election may have should be evaluated before making the selection. However, there are many opportunities and advantages for making an S-Corp election for family-owned businesses.
Employment Tax Saving Opportunities
Unique to the S-Corp taxing structure is the ability for a shareholder-employee to receive both a salary and distributions. The advantage of receiving both a reasonable salary and distributions is the ability to avoid employment-related taxes on the distributions (distributions are still subject to income tax). The IRS requires, in a situation where a shareholder is also an employee of the business, that the salary of the individual be reasonable. A reasonable wage is not a defined term but the IRS uses many factors to determine the reasonableness of the wage including the value of the services that the shareholder provides to the company, the value of services provided by non-shareholder employees, and the capital and equipment, used to generate gross receipts. Due to the distinct advantage of classifying certain “wages” as distributions, the IRS reserves the right to reclassify certain distributions as wages if it is determined that there was no reasonable bases for the classification. Therefore, it is important to consult with a tax professional when developing compensation plans for shareholder-employees.
An S-Corp has the distinct advantage of having the formalities of a C-Corp including having a board of directors, officers, and other common formalities, without having the rigidity of the double tax potential. For federal tax purposes, an S-Corp is treated as a pass-through entity. What this means is that the income, losses, deduction, and credits are “passed through” the business to the shareholders on a per-share base. Since there is no entity level tax, the shareholder can take advantage of passed-through items on their personal income tax return. This allows the shareholder to potentially reduce their personal income tax obligations. An S-Corp, unlike other pass-through entities like partnerships, has more restrictive rules around how certain items may be passed through to a shareholder. In addition, it’s important to consider the inability to retain earnings within the corporate structure. Therefore, it is important to take these factors into consideration when determining whether an S-Corp election is appropriate for your business.
Family Participation Planning
In order to maintain an S-Corp, the IRS has placed certain restrictions on the number of shareholders that are authorized. However, in order to encourage family-owned businesses, the IRS has changed the definition of a shareholder to allow certain groups to be classified as one shareholder for purposes of determining the 100 shareholder limit. For purposes of defining a shareholder of an S-Corp, spouses are treated as one shareholder. In addition, members of a single family unit, defined as a common ancestor or lineal descendants are treated as a single shareholder. Therefore, it is possible to technically have more than 100 “shareholders” if the shareholders are members of the same family. This creates a distinct opportunity for family-owned business to increase the number of outside participates while continuing to have family own stock in the company.
In addition, the IRS has a created a restriction on the ability to issues shares that have distinctive attributes (i.e. preferred shares). However, an S-Corp can have voting and non-voting shares as long as there are identical rights to distributions and liquidation proceeds. This creates an important advantage for family-owned businesses to issue non-voting shares to members of the family who are not active participates in the everyday activities of the business but want to contribute to its success.
Finally, an S-Corp election provides an opportunity for family-owned businesses to plan for their succession by providing opportunities for contributions to trust, shifting income from parents to children without triggering gift tax, and preventing the termination of the entity when a majority interest is transferred to another party. The rules around these opportunities are highly complex and therefore, it is appropriate to consult with a tax attorney prior to availing yourself of these opportunities.
Although not a commonly considered opportunity, an S-Corp election provides many opportunities for family-owned business to keep things in the family, take advantage of tax savings opportunities, and avail themselves of future succession planning. Although there are disadvantages, including additional tax filing requirements, it is important to consider all options when deciding what is best for your business. Robinson Legal can be a valuable resource in understanding whether an S-Corp election is appropriate for your situation and help you navigate the necessary formation requirements. Please feel free to reach out to us at www.robinsonltd.org or by phone at (614) 706-4317. #robinsonltd @robinson_ltd