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Understanding the Consequences of S Corporations

by Brett Backues on February 3, 2012
Business owners have the choice between several incarnations when deciding on the type of business they plan to operate. The choices often come down to decisions between basic liability and protecting your personal resources. 
Above all, tax considerations are the most common reason why small business owners choose to incorporate. Let’s talk about S corporations.
Many sole proprietors choose to incorporate themselves and their small business as an S Corp. When asked for their rational for choosing to be an S Corp, most business owners pointed their finger at their tax advisor, at their accountant or, in some cases, at their attorney. I’ve even had a few clients who have blamed their mother.
This worries me. Many people pick an entity for their business (sole proprietor, partnership, corporation, etc.) without understanding the possible consequences. Regardless of where the advice comes from, professionals should not issue a recommendation without understanding your business and the level risk you are willing to accept. As much as they wish they could, accountants, tax advisors and attorneys cannot read your mind. 
When talking with your advisor, don’t be hesitant in asking even what you consider to be ‘dumb’ questions. Asking questions can be vital to fully understanding the consequences of your decision.
Forming an S Corporation in the state of Washington starts with creating an LLC or some other type of corporation at the state level. (Washington does not recognize S Corporations and will tax your business the same as any other configuration of corporation.)
Receiving your federal Employer Identification Number (EIN) is only the beginning. As the business owner, you will need to follow-through by completing a Form 2553 for the Internal Revenue Service (IRS) to request that your company be treated as an S Corporation by the federal tax collectors. If you fail to complete the required paperwork your company will be taxed according to the defaults explained in last week’s blog (link).
Like a partnership, an S Corporation is considered to be a ‘pass-through’ entity, which means your tax forms will normally not indicate any taxes due. The tax return is simply information on the profits of your business, which means that each partner or principal will need to report their share of the profits on their personal tax return.
Unlike a partner in a partnership, the owner of an S Corporation is not considered self-employed, so the profits of the S Corporation are not treated as self-employment income.  This means profits are not subject to self-employment tax. This is may be why S corporations are so popular and how it can create its own set of problems.