There are some heightened requirements the business owner must satisfy yearly in order to maintain the S-Corp status. For example, the shareholders must (I repeat, must) adhere to corporate formalities, including holding regular and special meetings, keeping minutes of those meetings at the corporate headquarters and using a formal, written corporate resolution to document every single significant decision made on behalf of the organization by those running it. Failure to maintain corporate formalities can result in a host of significant tax ramifications, including facing double taxation and possible back taxes and penalties if your underlying entity is a C-Corp, and also being barred from using the S-Corp election again for five years.
The other little-known truth about S-Corps is that you will only really begin to see the financial benefits of it once your revenue is in the solid upper six figures. Remember to talk to your CPA about whether your company will truly benefit from this election because many do not.
A few other considerations to weigh: There are serious limitations on the number of shareholders an S-Corp can have, and you can only issue one class of stock to shareholders. Furthermore, your shareholders cannot generally receive special allocations of profits and losses, which may make it more difficult to raise capital through investors.
So, What’s The Best Option?
Even though an LLC is not the ideal fundraising vehicle, for many business owners, its advantages outweigh the S-Corp’s. For example, with an LLC, business debt generally increases the membership tax basis, meaning that members can deduct more losses from the business on their individual returns. And the higher the investor or member’s basis, the less capital gains are possible, which ultimately means less tax when she sells her interest or sells the business. So, although the S-Corp provides the benefit of lower self-employment taxes for its members, an inability to utilize business losses and debts could easily offset the benefit of having a smaller self-employment tax. And once you factor in its other limitations, the S-Corp will only be the right choice for a select group of businesses. When in doubt, you can’t go wrong with an LLC.
Regardless of which entity you choose, remember to consider state-specific tax information. Consult a local attorney (or an attorney in your jurisdiction of choice, such as Delaware) to determine which entity is ultimately the right one for your business.
To get more information about the author, Jessica Eaves Mathews, please see http://www.jessicaeavesmathews.com.