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James Sheets

Starting a business involves making so tricky choices. One of the most critical early decisions a business owner will make is the choice of business formation, answering the question of which type of business the owner will have. Brushing up on Indiana business law can help business owners answer that question.  Doing business as a corporation, of course, has its advantages. First, the owner receives the protection of limited liability, meaning that the corporation’s shareholders are only liable to the extent of their own investment.    

Second, there is the prestige factor. Being a corporation means that the business is, in fact, a separate entity or separate legal person. This means the business will have a life of its own. It can borrow money in its own name and stand before the law independently of its shareowners. And finally, a corporation has a board of directors or officers who make decisions on behalf of the corporation.    

But still, there is the ever-controversial double taxation factor. Because a corporation is independent and separate, it is subject to income tax and must pay taxes on its profits. Many people say this is fair because, as a separate person, it receives the same advantages as others and thus must pay taxes. Other people point to the issue that when the corporation pays dividends to its shareholders, this received income to the shareholders is also subject to taxation as the personal income level. Thus, corporations’ dividends are subject to a double tax or double taxation.    

No Double Taxation:  

Over the years, however, and with the change of tax laws, there has developed an exception to the rule of double taxation: the “S” Corporation. Under IRS rules for corporate taxation, a corporation can remain a standard “C” corporation. Under certain circumstances, it can opt-in to become a “S” Corporation. The important idea is that the corporation is a “pass-through” business. This means that for all practical purposes, the losses and the profits are not taxed or deducted at the corporation level but “pass-through” the corporation untouched by any tax law and are treated or taxed only at the shareholder level.    

S Corporation Like a Hybrid Corp  

The S corporation, thus, can be treated as a hybrid organization in that it has the protection of a regular corporation in that it retains the limited liability of a corporation and the formalities of a corporation with its board of directors but has the tax advantage similar to that of a partnership in which the profits and losses accrued by a partnership is “passed through,” to the individual partners and as such taxed as personal income.    

S corporations thus have certain advantages over the larger and standard “C” corporations. In addition to not being subject to taxation at the entity level, when salaries are paid out at the corporate level, this will lower the tax liability that the individual shareholder has at the personal income level if they were otherwise self-employed.    

A related tax benefit is that losses sustained at the corporate level can be passed through to the personal income tax level and be deducted as losses again the overall personal tax liability. Thus, S Corporations allow individual shareholders to deduct the losses sustained at the corporation level from their overall individual liability.  

Who Can Be a S Corporation:  

There are some requirements; however, they must be satisfied for quality as a S Corporation. First, the corporation can only have one class of stock rather than two. This generally means that the S corporation only has common stock and not preferred stock. This is required to avoid what might appear to be special distributions if profits are distributed as dividends of preferred stock. The following requirement is that an S corporation cannot have more than 100 shareholders.    

Thus, S corporations tend to resemble a closely held corporations or a corporation owned by comparatively few shareholders. The S corporation, under IRS rules, comes with a family exception in that a husband and wife are treated as a single shareholder. If other family members own the S corporation, these people will also be treated as a single persons under S corporation rules.    

S Corporation not Publicly Held  

This family-style ownership of a S corporation means that a S corporation will not qualify as a publicly held corporation in which investors from the broader public can participate in ownership. This rule is significant because a S corporation usually has another corporation as a shareholder.    

Therefore, with a few exceptions, it can never become a subsidiary of another corporation. The exceptions included certain trusts, tax-exempt 501 c 3 corporations, nonprofits, and certain estates. Instead, a small number of investors generally own an S corporation. The third requirement is – with a few exceptions – only US individuals, citizens, or residents can own a share of a S corporation.  

The ownership rules of an S corporation means that, like other closely held corporations, there are definite restrictions on who can become a S corporation shareholder. While a S corporation does not come with a first option to buy restrictions in their articles of incorporation, a shareholder in a corporation cannot sell their shares in the broader share markets that govern the sale of C corporation shares.  

The Reasons for a S Corporation:  

The reasons the S corporation came to be somewhat historical. In the mid-twentieth century, US president Dwight Eisenhower believed that corporations in America were becoming too large and had too much influence, and was consolidating wealth into the hands of a few wealthy shareholders. To prevent this and to provide greater access to corporate opportunities to ordinary people, Congress created in 1958 the S corporation to provide to a corporate business protection while still maintaining the ownership patterns of a partnership.    

Several reasons were made at that time to justify the creation of an S corp. One is the idea of vertical fairness, which is meant that an S corporation tax rate is intended to bring to the small businessperson a tax rate benefit that will allow them to compete with larger corporations. The S corporation is thus consistent with the principle of progressive taxation.  

Second, the S corporation was defended as being more efficient than the C corporation in that there is no corporate tax on an S corporation. Thus it does not have to factor in taxation in its decision-making process.  

Third, the S corporation simplifies the tax law in that taxation at the individual non-corporate behavior is easier to understand than at the corporate level.  

Status Factor of S Corporation vs. Partnership  

There is also a status factor in owning a S corporation rather than a partnership. This partly comes from its status as an entity and having a separate existence as an entity rather than a partnership business activity or sole proprietorship. A corporation has formalities of officers, and each with its distinctive role: the president, vice president, treasurer, and secretary.  

Becoming or electing to become a S corporation is done by completing and filing with the IRS the S corporation election form 2553. One important rule is that the election to become an S corporation must be done shortly after the start of the tax year on or before the 15th day of the third month of the tax year. This is done to prevent a larger and more developed corporation with years of corporate history from taking an unfair tax advantage which comes to a smaller and more closely held corporation. Failure to make this early opt-in election during the first quarter can be fatal to becoming an S corporation, so planning is advised when becoming an S corporation.  

An “S” Corporation under Indiana Law  

Fortunately, it is relatively easy to create an S corporation under the state, including the law of Indiana. First, you will need to decide upon a designated name. The name must be unique so that it would not be confused with another business name in the state. The best way to do this is to complete a search on the Indiana Secretary of State website to see the list of existing names and if the name you have chosen is confusingly like an existing name. Once you have your existing and unique name, you can reserve the name for up to 120 days.  

Second, as this is an S corporation, you will need to place an entity designation behind the name, either “Inc.,” designating the business as incorporated, or “Corp,” also to designate the business as a corporation.    To learn how to maintain an already existing S Corp read our article, How To Maintain Your S-Corp.  

Registered Agent  

Third, an S corporation, like any other business in the state of Indiana, must have a registered agent with a physical address within the state. This is important because the registered agent’s purpose is to accept service for legal purposes. This means the address cannot be a PO box, and the agent must make him or herself available upon request for legal purposes to receive mail.  

Self as Corporate Agent  

Sometimes it is common for a person just starting up a corporation to decide to have him or herself serve as a corporate agent. This can save money, but it can also create problems in that if the person’s address is used and subsequently changes, the business address will also need to be changed. A registered agent can help establish continuity as well as ensure compliance.  

Articles of Incorporation  

Next, the Articles of Incorporation must be drafted and filed with the state. The article of incorporation provides the public notice of the corporation’s existence and its basic structure, as it by law, must provide the corporation name, identify the purpose of the corporation, identify the incorporator or founder, the name and address of its legal agent, the name of the officers of the corporation, the type of stock and the initial number of shares of stock, the duration or time of corporation which for an S or C corporation is indefinite, the existence of any restrictions of share, the presence of any preemptive rights for the shareholders, the indemnification or the protection of its directors or officers, and finally provide for the creation of the corporate bylaws.    

Tax-Related Matters  

There are then two tax-related matters. An employer Identification number or EIN must be obtained from the IRS requesting this number. Usually, this is done online, and finally, filing the S corporation election from 2253 with the IRS. Each year, the corporation will need to file an 1120s form at the federal level, which will then be included with each shareholder’s personal 1040 tax form. At the state level, in Indiana, each shareholder must file the Form IT-20s.    

Indiana, like many other states, because it recognizes the S corporation election, does not tax the S corporation at the corporate level; it does, however, require each S corporation shareholder to pay tax on their appropriate share of the corporation’s income at 3.23 percent once it is adjusted as grown income. Other required forms to be used in an S corporation are Form 941 for social securities and Medicare taxes and income withholding taxes and Form 940 for unemployment taxation.  

Salary versus Profit Distribution:  

One of the critical issues when running an S Corporation is the salary for the chief officer, who usually also happens to be the owner. There is tension in an S corporation to pay out profit distribution rather than pay out as salary, given that the latter is subject to a 13% wage withholding. Therefore, the IRS requires that an S corporation owner pay him or herself a reasonable salary rather than just dipping into the profits every payday.  

What is a Reasonable Salary?  

As a rule, a reasonable salary is a salary like what someone else in the same line of work. While this sounds kind of vague, some more specific factors can be referred to in understanding reasonable salary, including what comparable businesses pay for similar services, the training and experience of the person performing the work, the effort and time required to do the work, applicable employment agreements, the S corporation dividend history versus the salary paid during the same pay period, and the compensation paid to non-shareholder employees.  

More specific reasonable compensation information can be found on employer review sites such as Glassdoor or at the Bureau of Labor Statistics. Yet even here, the idea of reasonable compensation can be complicated because many S Corporation owners wear various hats when working for their own S corporation. If necessary, the reasonable compensation number can be adjusted downward if you work part-time, which is considered less than 2,080 hours annually, or if the S corporation income sources can be attributed to a particular asset or the merits of the employees.  

Safe Harbor Rule  

There is, however, a rule of the safe harbor, generally referred to in assessing reasonable compensation versus distribution of profits. This is the sixty versus 40 rule or the sixty percent profit versus 40 percent profit rule. One point to remember, though, is that unless the S corporation has been historically unprofitable and not showing profits, owners of an S corporation need to be fair to themselves at the reasonable compensation rule by paying themselves a reasonable compensation to avoid IRS scrutinization. One further point to remember is that in an S corporation, every officer, the president, vice president, secretary, and treasurer, in addition to their officer role, are treated as an employee of the corporation and must be paid compensation as an employee.  

Frequency of Salary Paid Versus Profits  

Another compensation factor that needs to be considered is the frequency that salary is paid versus the frequency that profits are distributed. The more regular and systematic salary is paid, the less risk there is that income is unfairly characterized as profit distribution. Salary should be paid at least once a quarter, if not once a month, with profits being distributed not more than quarterly, if not yearly. All of this will need to be disclosed on the yearly 1120s Schedule K-1.  

The payment of reasonable compensation over an extended period brings up the issue of unemployment benefits if the owner of the S corporation becomes unemployed by their own compensation. Can an S corporation owner collect unemployment as the unemployed owner of their own S corporation? Technically, the answer is yes, but remember, the longer the unemployed owner collects unemployment benefits, the less likely the corporation can stand in business.  

Harsh Penalties  

Remember, though, that the IRS can impose harsh penalties on an S corporation that failed to observe the requirement of reasonable compensation. In instances where an S corporation has failed to withhold unemployment and social security monies, the IRS can impose a penalty of twenty percent in addition to going back and withholding on unemployment and social security withholding. Interest also be factored into the total amount to be recharacterized as a salary.  

There have been many IRS cases in which owners of S Corporations have faced significant fines for failing to provide reasonable compensation. In addition, the IRS will also scrutinize internal transfers between shareholders, characterized as loans that are forms of disguised compensation.  

The S Corporation and the LLC:  

S corporations have proved to be very popular because they provide business owners with a more flexible and less cumbersome option than the C corporation. Some critics, however, have suggested that the S corporation has outlived its purposes with the coming of the popular limited liability company, or LLC.    

Like the S corporation, the limited liability company is a hybrid entity having the qualities of both a partnership and a corporation. Like a corporation, the LLC enjoys limited liability, and the shareholders can only lose the extent of their contributions. And like a partnership, the LLC is not taxed at the entity level. This is because the limited liability company is, in fact, not an entity but simply an agreement between its shareholders, who under the law are referred to as members.  To learn more about what sets apart an S Corp from an LLC read our article, LLCs Vs. S-Corps.

Advantages of LLC versus S Corporation  

The advantage, however, that the LLC enjoys over the S corporation is that it does not have restrictions on shareholders. This allows an LLC to bring in outside investors from the public without regard to their residency or if the shareholder is a natural or legal person. Another advantage of an LLC over an S corporation is that it has fewer corporate formalities to observe and thus does not have to have annual shareholder meetings, board of director governance rules, or outside reporting requirements.  

LLCs have also become popular because these organizations do not need to observe corporate formalities. Unlike a corporation, an LLC does not need to hold annual meetings with its shareholders, does not have to keep corporate filings, and does business in accordance with its operating agreement, which is generally found to be more flexible than the bylaws used in a corporation.    

Downside of LLC versus S Corporation  

The downside for the LLC is that its financing options tend to be more limited than that of an S corporation. This is because the LLC is not an entity under the law, and its financing can only be done at the individual level between the members and outside financial institutions, many of whom will not lend at the individual level because of the higher risk.    

Nevertheless, the S corporation and the LLC each have advantages and disadvantages. In knowing your business needs, one can choose the organization best for your business purpose.

Disclaimer: The information provided on this blog is intended for general informational purposes only and should not be construed as legal advice on any subject matter. This information is not intended to create, and receipt or viewing does not constitute an attorney-client relationship. Each individual's legal needs are unique, and these materials may not be applicable to your legal situation. Always seek the advice of a competent attorney with any questions you may have regarding a legal issue. Do not disregard professional legal advice or delay in seeking it because of something you have read on this blog.

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