S-Corporations are best utilized for operational businesses with a product or service income. They should generally be undercapitalized as a “shell” for asset protection. The S-Corp has often been said to provide the “best of both worlds.” Its advantages include limited liability for shareholders and it is considered a standard corporation under state law. However, by making a special S-election with the IRS, it provides a single level of taxation very similar to that of a partnership.
Through the use of an S-Corporation, the entity does not pay corporate-level taxes. Profits are passed through to the shareholders, who pay personal income tax. A tremendous advantage is that the earnings can split between salary and dividends to save dollars on the dreaded self-employment tax (FICA).
Although the S-Corporation has numerous benefits, it still is considered to be a very inflexible form of doing business. Sharing profits and losses with shareholders in a creative manner is virtually impossible, and owning long-term rental properties is not recommended in an S-Corporation. Tax deductions for fringe benefits in an S-Corporation are also extremely limited.
Finally, in order to maintain the ‘corporate veil’ and the benefits of asset protection, it is important to record annual minutes, utilize separate checking and bookkeeping for the entity, and remembering to employ the corporate name on all legal documents and advertising material. The S-Corporation must file an annual tax return using IRS form 1120S.