In today’s economic and employment landscape, starting your own business and following your real dreams — not simply your realistic ones — can be exciting. However, it doesn’t matter how great your business idea is or how much revenue potential it has...you still need to take the most sensible steps to form and structure your business. Many individuals who go into business are familiar with LLCs and the concept of sole proprietorship. But knowing when to create an S Corporation for your business is a topic that doesn’t come up until later, usually when a lawyer or accountant recommends it.
Don't get us wrong: Forming an LLC is a great start and an essential first step to starting a business. But depending on your business goals and financial situation, it might be worth considering the many advantages of forming an S Corporation instead, or electing to file taxes as an S Corporation.
Let’s take a look at five of the primary S Corporation benefits for entrepreneurs.
1. Pass-Through Taxation
S Corporations are one of the most popular business entity structures because they can be treated as pass-through entities for tax purposes (also known as “flow-through taxation”). Essentially, this helps the shareholders since they'll only pay taxes as individuals, instead of being taxed twice: once on the corporation's income, and again on income that appears on their personal income tax returns.
While this may sound great, you need to be sure you meet all the qualifications for structuring your company as an S Corporation before taking advantage. For instance, only individual business owners can use this entity structure. If part of your business will be co-owned by an LLC (even 1 percent), you will likely have to structure it as a C Corporation.
2. Protection From Liability
S Corporations can help shield their owners from personal liability, such as lawsuits that can be an unfortunate part of doing business. What many business owners love about S Corps is they offer the same protection from personal liability as C Corporations. In most cases, this means your personal assets may not be seized as a result of a lawsuit.
When you start any business, you probably understand the risks as part of the thrill of entrepreneurship, (even if they can be scary sometimes). But even with the known risks, there's no need to take unnecessary ones — especially when you could lose your home, car, personal funds, and other assets.
3. Simple to Transfer Share Ownership
S Corporations make it simple for shareholders to come and go, as they're likely to do in startup businesses. You may go through several rounds of funding and want to simplify the process and reduce the expense of bringing people on or buying them out. An S Corporation makes this simple: You only need to buy and sell shares of the company.
This also makes it easy to transfer ownership to someone else if you decide to sell your company and start something new. Many entrepreneurs get excited about starting companies and helping them take off before moving on to their next adventure in business. If you want a nimble structure for your company, an S Corporation can be useful in this regard.
4. Not Personally Responsible for Company Debt
Most companies have to rely on accumulating some form of debt in order to get off the ground. Sometimes, this is preferred to taking on investors in the early phases when your equity isn’t worth as much. Until you get some sales under your belt, taking on debt is sometimes a necessary part of acquiring equipment, buying inventory or paying overhead for day-to-day operations. Whether you use a business credit card or take out a small business loan, do everything you can to protect yourself from footing the bill for company debt if issues arise. This is just as important as protecting your assets in the event of a lawsuit, and it’s one of the top S Corporation advantages for many startups.
Important Note: Even though this protection is a key benefit, don't automatically assume you won't be held personally responsible for your business debts! Having an LLC or S Corporation is not a license to recklessly borrow money — you need to follow the right procedures and compliance practices to avoid having creditors go after your personal assets in the event of a lawsuit.
For example, sometimes judges will find the owner of a small business to be personally liable for that business’ debts if they “pierced the corporate veil.” There are several ways this can happen:
Failure to maintain your business entity in good standing with regulators
Failure to follow the formalities of operating your business as a legal corporate entity that is separate from your personal identity
In any of these cases, you could be at risk for having your corporate veil lifted, and become personally responsible for paying your business debts or lawsuit judgments. No matter which entity type you choose, talk to an attorney if you have any questions or concerns about your possible legal risks and liabilities.
5. Cash vs. Accrual Method for Accounting
There are benefits to cash and accrual accounting, and S Corporations allow you to take advantage of both in their own ways. For taxation purposes, you can use cash-based accounting, which is a much simpler method. However, accrual-based accounting can be used internally, and it helps you get a clearer picture of your profits and losses from month to month.
With cash accounting, you record expenses as they go out and income when it actually comes in (not when you invoice for it). With accrual accounting, you count revenue from invoices when you bill customers, even if they haven't paid yet. This can help you understand how well you performed in real time. For business owners who use Quickbooks, it's easy to run reports and gauge performance every month, no matter which method you use.
Are you ready to start your S Corp or LLC? Incfile can help you take the next steps in organizing and structuring your business. We offer affordable service packages for entrepreneurs, and we can help you bring your innovative business idea to life while protecting your personal assets from the risks and liabilities of business ownership.
Ben Gran is a freelance writer from Des Moines, Iowa. Ben has written for Fortune 500 companies, the Governor of Iowa (who now serves as U.S. Secretary of Agriculture), the U.S. Secretary of the Navy, and many corporate clients. He writes about entrepreneurship, technology, food and other areas of great personal interest.