Sorry, But You Can’t Actually “Form an S-Corp”

When I ask business owners what type of entity they’ve already formed for their business and they answer “I formed an S-corp,” I start to cringe.

I don’t cringe because they’re wrong (which they are).  I cringe because they are lacking basic knowledge about a fundamental part of their business.  If you don’t know everything there is to know about your business, let alone the type of entity you formed, it makes it that much harder to succeed.

You cannot ‘form an S-corp.’ This is because an S-corp is not actually a type of business entity.  It is merely a tax classification.

Legal entities, such as corporations (often called C-corps) and limited liability companies (LLCs) are formed at the state level.  For example, if you want to form a Florida corporation, you must do so through the Florida Department of State. You simply have no other choice.  Even if you use an online service to form your Florida corporation, they will have to go through the Florida Department of State in order to do so.  The bottom line is that nobody else can grant you a Florida corporation.

S-corp status is a tax selection.  You do not obtain it at the state level (such as the Florida Department of State).  Rather, it is made on the federal level (with the IRS).

You first must have already formed a corporation or LLC in order to elect S-corp status.

Many business owners choose to form a corporation when starting a new business.  One problem with corporations is that they are subject to double-taxation. This means that they are taxed twice: first on the corporate level, when the corporation earns revenues; and then the shareholders are taxed individually when they are paid corporate dividends.

This is not an optimal tax situation.  The words ‘double-taxation’ don’t sound like something that you might ever actually want, do they?

From a tax perspective, partnerships benefit from a lower tax bill due to “pass-through” taxation.  This means that the partnership itself is not taxed, only the individuals partners. There is only one level of taxation and no double-taxation, as with a corporation.

Although this is certainly beneficial from a tax perspective, the downside of operating your business as a partnership is that partners of a partnership are subject to full personal liability for all business debts.  This is unlike shareholders of a corporation, who’s personal, non-corporation, assets are shielded from such business debts.

By electing S-corp status, a corporation maintains its limited liability, while avoiding double-taxation.  

Unlike corporations, LLCs are ordinarily taxed depending upon the number of members (owners) of the LLC.

If the LLC is a single-member LLC (meaning that there is only one owner), then an LLC is taxed as a disregarded entity/sole proprietorship.  There is no need for an additional tax filing. With multi-member LLCs (that’s right, that’s when there is more than one owner), the LLC is taxed like a partnership.   However, multi-member LLCs may also elect S-corp status.

Both LLCs and S-corps have pass-through taxes.  This begs the question why would an LLC bother electing S-corp tax status?

The main reason is because of self-employment taxes.  An LLC is required to pay self-employment taxes, which covers items such as Social Security and Medicare at the standard rate (which is above 15%).

Let’s say Bob owns an LLC that has elected S-corp status (notice how I didn’t say that Bob formed an S-corp!).  As an employee of the business, Bob would have to pay self-employment taxes on any income he takes in the form of salary.  However, if Bob takes any money out of the entity in the form of a distribution, it is taken free of self-employment taxes.  The S-corp allows the business to retain more profit by bypassing self-employment taxes on money distributed to its owners.

If you are thinking of starting a business, you should certainly have an attorney available to assist you with all facets of its formation.  Should you find yourself in this position, contact the Greenbaum Law Firm, P.A. to schedule a consultation today.

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Greenbaum Law Firm, P.A.

The Greenbaum Law Firm, P.A. is a boutique, client-centric law firm concentrating in the areas of business and corporate law, contracts and agreements, and real estate. Our unique approach to the practice of law consists of positioning our clients at the center of the legal practice and pursuing their objectives in the most efficient and transparent manner.

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