What is an S Corporation and Why Form One in Massachusetts?

The “S Corporation” gets its name from the IRS code provision (Subchapter S) that allows for a shareholder-owned corporation with just one layer of tax (as opposed to a Subchapter C corporation that is taxed twice: once on corporate profits and then a second time on proceeds to shareholders). The S Corporation is formed at the state level, e.g. here with the Massachusetts Secretary of State, but tax benefits are seen mainly at the federal level under the IRS. S corporations have certain restrictions, for example that shareholders are limited in number to 75, which explains why larger C corporations exist in spite of the double tax. What follows is a more in depth treatment of what makes an S Corporation unique. To understand general characteristics check out our earlier summary regarding important differences between the LLC and S Corporation.

Other Tax Considerations in a Massachusetts S Corporation

Forget for a moment what you just read about the tax differences between the S Corporation and the C Corporation. For any small company, opting for the “S” in that situation if they can meet the shareholder requirements is a no-brainer. The real decision for the small business owner is whether to form an S Corporation as opposed to other small business entity forms, e.g. the single proprietorship, partnership or additional limited liability entities like the Limited Partnership or Limited Liability Company. And yet, it is again considerations of tax liability that drive these decisions. So what are these tax considerations?

• Outside Investments: Non-U.S. investors seek shares of S Corporations rather than LLCs because such interests will not subject them to taxation within the United States.
• Mergers and Acquisitions: If the company may be acquired by another down the line and a share exchange takes place, the receipt of shares in exchange for LLC interests will trigger tax liability for those shares. This is particularly troublesome for the LLC owner if the shares are not able to be sold for a certain period of time after the exchange.
• Sale of Business: If the company owner sees himself selling the business to another sole owner or LLC down the line, whereby a simple asset sale will take place, then it is almost always a better plan to have an LLC. S Corporations, like C Corporations are subject to a double tax in such situations whereas an LLC will only be taxed once.

Salary vs. Distributions under the S Corporation – The Big Tax Consideration

S Corporations in Massachusetts can attribute their popularity versus other limited liability entities mainly because due to the separation of profits into “salary” and “distributions.” Salary is subject to the onerous self-employment tax e.g. Social Security and Medicare, whereas distributions generally are not.

What’s so bad about self-employment tax? Self-employment tax is much like the tax on any employee’s W-2 forms that goes towards Social Security and Medicare as described above. But in the case of W-2 employment, the employer pays half that amount – about 6%. A self-employed individual, by contrast, must pay both the employer amount and the employee amount – more like 12%! No matter how much a business owner has makes, this is a significant share of the profits. So the S Corporation offers a way to avoid these high tax percentages by issuing part of that compensation in distributions.

Dividends may not be subject to the self-employment tax, but they are of course included in each shareholder’s individual income, to be taxed at his or her state and federal income brackets. Keep in mind, too, that this does not mean all income may be received as dividends without the IRS taking notice. Typically an accountant will attribute distributions at 40% of an individual business owner’s compensation, with the remaining 60% being taxed as salary.

Potential Drawbacks with a Massachusetts S Corporation

With such tax advantages, it may be difficult to understand why every Massachusetts small business doesn’t form as an S Corporation. The answer is that due to limitations (some outlined above), and other complications, the advantages of an S Corporation are only clear in rather specific situations. The profit of a company, the way decisions are made, the way checks are written, and the potential variations of interests in a business will dictate whether these advantages are actually worth incorporation.

• Profits: Additional costs will be necessary in an S Corporation that may not be present in an LLC. If an outside accountant is used, for example, he or she will need to reconcile each payment as either a salary paycheck or distribution, whereby a K-1 must be issued. Also, in states like Massachusetts there will be an minimum excise tax assessed on the business each year in addition to the state’s annual filing fees for the entity. The business owner needs to examine whether his or her budget will account for these expenses.
• Decision Making: An S Corporation must observe certain formalities that the LLC does not, for example accounting for minutes at monthly meetings regarding decisions made out of the usual course of business – even in the case of a sole proprietorship! A restaurateur under an S Corporation, for example, could order inventory without notice of approval in the form of board minutes, but probably could not order a new ice machine. This is where we as Massachusetts business formation lawyers are concerned, for the risk here is losing limited liability, where the owner himself could be sued for the corporation’s liabilities.
• Interests: An S Corporation generally can only issue one class of stock, that is that all owners have more or less equal rights (according to his percentage of shares). There is some flexibility with respect to voting, but that is basically the only variation available. An LLC, by contrast, can have any number of different interests in its operation, and moreover can have persons or non-persons as members. S Corporations are much more restrictive with respect to such interests.

Final Considerations – A Caveat on LLCs versus S Corporations in Massachusetts

At present, whether a business is registered in Massachusetts as an LLC or as an S Corporation does not matter with respect to self-employment taxes. This is because current IRS tax regulations permit an LLC to file what is known as a Form 2553 election to be taxed as a corporation. As such an LLC may very well issue both distributions and salary as compensation with the same advantages as an S Corporation, but without subjecting itself to the necessary formalities. And while many accountants fear this loophole may one day be closed, the strategy may be a good one for a startup seeking to control costs. And, given that many Congressmen have LLC’s that probably enjoy such tax treatment, these loopholes may not close anytime soon.