By default, when you form a corporation, you’re established as a C-corporation. However, you have the option to elect to be an S-corporation.
What is a S-corp? And why would you want to choose an S-corp over C-corp?
A S-corp is a tax classification that provides personal liability protection and passes income through owners. S-corps are not subject to federal income tax and therefore avoid double-taxation and help lower self-employment tax.
In this article, we dive deeper into the subject and explain how an S-corp works to help you decide whether it’s right for your business situation.
What’s the Difference between
an S-Corp and a C-Corp?
The biggest difference between an S-corp and C-corp is the tax benefits. S-corps are considered a flow-through tax entity, much like an LLC, sole proprietorship, or partnership. This means the profits and losses flow through to shareholders’ personal tax returns.
If business owners want to be taxed as a S-corp, the entity must meet these requirements:
- - Having less than 100 employees
- - Must be owned and operated in the United States
- - Shareholders cannot be part of another corporation
- - Only one class of stock permitted
How is an S Corp Taxed?
As a pass-through entity, S-corps don’t have to file and pay corporate income taxes. Instead, the owners separate the earnings and losses and report it on their personal return. This allows for S-corps to avoid the double-taxation that C-corps face.
Due to its tax structure, the earnings of S-corps are taxed when paid out as bonuses (dividends) and salaries. Therefore, larger corporations are subject to saving thousands on taxes.
Filing as a S-corp sounds easy enough, but it’s best to have a qualified person assist you because even the smallest mistake on the paperwork could result in the business being classified as a C-corp.
Additional taxes to make note of are:
- Payroll taxes – In Arizona's, the maximum payroll tax is 4.9%
- Franchise Taxes – Arizona does not have any franchise or privilege tax
Why Choose an S Corporation?
As a corporation, you’re subject to several benefits such as personal liability protection and the ability to provide preferred shares. Choosing to file as an S-corp comes with it’s own set of advantages.
Because of how they are set up, S-corps avoid double-taxation. Owners only pay taxes on their personal income tax return. This can result in more profits for the business.
The decision to form a C-corp and S-corp boils down to the profits you plan to make from the business.
As a S-corp, you can lower the tax bill of all shareholders if you plan on taking earnings out of the company as distributions. If your company is up-and-coming and plans to reinvest the earnings into the business, then filing as a C-corp may help lower your tax bill.
Advantages of an S-Corp
There are many reasons to create an s-corporation in Arizona. If you aren’t sure if a s-corp is right for you, consider some of the benefits they have to offer.
Personal liability protection – Creditors cannot take personal assets of shareholders to pay business debts.
Pass-through taxation – S-corps don’t pay federal taxes at a corporate level.
Credibility – New businesses benefit from having an S-corp name because it increases trust and credibility among employees, customers, and vendors.
Characterization of distributions - A reasonable characterization of distributions as salary or dividends to S-corp employees can reduce self-employment tax liability, while still having the ability to deduct business and wage expenses.
Investment opportunities – S-corps can obtain funding easily because stocks can easily be purchased and sold.
Transfer of ownership – There are no adverse tax consequences of transferring ownership of an S-corp.
Annual tax filing – S-corps are only subject to filing taxes once a year, compared to C-corps that must file quarterly.
Disadvantages of an S-Corp
While there are many advantages of creating an S corporation in Arizona, there are downsides. Here are a few disadvantages of Arizona s-corporations.
- Ongoing expenses
- Calendar year adoption
- Restrictions on stock ownership
- Tedious tax qualification obligations
- Less flexibility in allocating income and losses
- Only 100 shareholders permitted
- More IRS scrutinization
The benefits of an S-corp often outweigh the drawbacks, especially for new businesses. Choosing to form an S-corp depends on your business goals, structure, and how you plan to make profits.
It’s always best to consult with an experienced professional before choosing how to form your corporation. They can advise you on whether an S-corp status is right for your unique business situation.