The tax benefits of an S corporation

Eligible corporations in Kentucky can elect to be taxed as S corporations with the IRS, which can potentially reduce shareholder tax burden while protecting the personal assets of large stakeholders. Requirements for S corporation eligibility include having only one class of stock and no more than 100 shareholders.

S corps are unique legal entities, separate from shareholders. Only in certain circumstances can others "pierce the corporate veil" and target the personal assets of shareholders. This provides an invaluable protection for business owners who are attempting to create or expand their business without putting their home and life savings on the line.

However, many businesses choose an S corp as their choice of entity for tax reasons.

Favorable characterization of income and double taxation avoidance

The IRS taxes corporations as separate legal entities from its shareholders. For closely held businesses, this essentially amounts to double taxation - you must pay income tax on business income and on personal income.

In an S corp, however, Kentucky allows "pass through" taxation, meaning the corporation is not taxed as an individual entity.

In addition, shareholders can draw a salary from the business and pay taxes as employees, thereby avoiding high self-employment taxes.

Other benefits of an S corp

In addition to tax benefits, S corporations can benefit shareholders through:

  • Greater transferability. Interests in an S corporation can be transferred with minimal impact on the business or on tax consequences. This is not necessarily true in an LLC or LLP.
  • Formalized operations. S corps require shareholder meetings and adoption of bylaws, among other requirements. This can be onerous, but it can also reduce the chances of future internal disputes.
  • Credibility. Because of its increased formal requirements, electing S corp status can enhance a company's brand, particularly if the business is just starting out or seeking to expand.

Election must be done in accordance with IRS regulations

Mistakes in forming an S corp can have negative consequences. For example, while shareholders may have a reduced tax burden by representing themselves as employees, they must be paid a reasonable wage. Failing to do so can result in higher employment taxes. The IRS also tends to audit S corporations more frequently than other business entities, particularly if there are red flags such as a low salary with high distributions.

Failing to abide by formal requirements may also put a business' S corp status at risk.

Questions? Contact an experienced business formations law firm.

There are benefits and potential drawbacks in any business entity. While an S corp can provide significant benefits, it is only an appropriate choice of entity under certain circumstances. If you have questions regarding the appropriate legal entity for your business, contact an experienced business formations attorney.

Landrum & Shouse LLP, is a prominent Kentucky business and commercial law firm with offices in Lexington and Louisville.