Tax Brief: Choosing an Entity for your new business

If you’re starting a business with some partners and wondering what type of entity to form, an S corporation may be the most suitable form of business for your new venture. Here are some of the reasons why.

A big benefit of an S corporation over a partnership is that as S corporation shareholders, you won’t be personally liable for corporate debts. In order to receive this protection, it’s important that:

  • The corporation be adequately financed,
  • The existence of the corporation as a separate entity be maintained, and
  • Various formalities required by your state be observed (for example, filing articles of incorporation, adopting by-laws, electing a board of directors and holding organizational meetings).

Dealing with losses

If you expect that the business will incur losses in its early years, an S corporation is preferable to a C corporation from a tax standpoint. Shareholders in a C corporation generally get no tax benefit from such losses. In contrast, as S corporation shareholders, each of you can deduct your percentage share of losses on your personal tax return to the extent of your basis in the stock and in any loans you made to the entity. Losses that can’t be deducted because they exceed your basis are carried forward and can be deducted by you in the future when there’s sufficient basis.

Once the S corporation begins to earn profits, the income will be taxed directly to you whether or not it’s distributed. It will be reported on your individual tax return and be aggregated with income from other sources. Your share of the S corporation’s income won’t be subject to self-employment tax, but your wages will be subject to Social Security taxes. To the extent the income is passed through to you as qualified business income (QBI), you’ll be eligible to take the 20% pass-through deduction, subject to various limitations.

Note: Unless Congress acts to extend it, the QBI deduction is scheduled to expire after 2025.

If you’re planning to provide fringe benefits such as health and life insurance, you should be aware that the costs of providing such benefits to a more than 2% shareholder are deductible by the entity but are taxable to the recipient.

Protecting S status

Also be aware that the S corporation could inadvertently lose its S status if you or your partners transfer stock to an ineligible shareholder such as another corporation, a partnership or a nonresident alien. If the S election was terminated, the corporation would become a taxable entity. You would not be able to deduct any losses and earnings could be subject to double taxation — once at the corporate level and again when distributed to you. In order to protect against this risk, it’s a good idea for each shareholder to sign an agreement promising not to make any transfers that would jeopardize the S election.

Before finalizing your choice of entity, consult with us. We can answer any questions you have and assist in launching your new venture.