Should Your Business Be An S Corp?

Entity choice is never easy or obvious. For the established small business, the S corporation form may be the best. Deciding whether it is right for your business means looking for certain characteristics in the business.

• The business must be “established”. This means it is:

o Profitable. This means more than basic balancesheet profitability. It means the business must be generating profits after owner compensation. The reason is that one of the main advantages of an S corporation election is employment tax savings. These savings are possible because owners of business enterprises operated as sole proprietorships, partnerships (including limited liability partnerships), and limited liability companies are subject to selfemployment tax on the income of the enterprise if they participate actively in its business affairs or are entitled to be involved in its management. The savings can be substantial, but evaporate if the business is not profitable.

• The business must be permanent:

o Any business likely to reorganize ownership is not permanent. The reason for this is the lockin of assets that cannot be withdrawn or put into a new entity (other than another S corporation or a C corporation) without tax consequences.

o Corporate ownership must be continuing. The Internal Revenue Code requires each business ending up in a corporation owned by one of the S corporation’s shareholders be an active business with a fiveyear operating history.

• The business must be small. This is primarily a function of the number and type of owners a business has. It is also determined in part by the nature of the business’s activities and the amount of income:

o As for type and number of owners, the business must be operated as a corporation created in the United States and have a maximum number of shareholders. Being a small business corporation also requires all shareholders be individuals who are citizens or residents of the United States, estates, and certain types of trusts. An S corporation cannot have a shareholder that is a corporation (unless it is a wholly owned subsidiary of another S corporation) and cannot have shareholders that are partnerships or limited liability companies.

o For activities and income, the Code sets no limits on the amount of assets an S corporation may have or on the amount of income it may earn. The Code does, however, prohibit financial institutions, insurance companies, and corporations entitled to certain tax benefits associated with foreign trade from being S corporations.

• The enterprise must be a “business.” The rule of thumb favoring the use of an S corporation for an established small business applies only if an enterprise conducts an active business; not being involved in investment activities.