Tax Law Keeps S Corporations Attractive

One fortunate outcome of the 2010 Tax Relief Act is that it keeps the top individual income tax rate almost 5 percentage points lower than the statutory U.S. corporate tax rate. The difference between individual and corporate tax rates is one of the incentives for organizing as an S corporation.

Taxes are really the primary consideration when deciding whether to organize a small business as an S corporation. But some businesses may find that the costs of complying with Subchapter S of Chapter 1 of the Internal Revenue Code could offset the tax advantages. It’s important to weigh the cost of these requirements against the potential benefits of incorporating.

Tax Returns, but No Taxes

S corporations are rarely subject to a corporate income tax; rather, their profits (and losses) are passed through to shareholders, who are taxed at the lower individual income tax rates. (A recent decision in Japan to cut the corporate tax rate by five percentage points means that the United States could have the highest effective corporate tax rate in the world.)^1–2

Despite their potential lack of tax liability, S corporations must still file tax returns. They must also file certain legal documents and maintain a board of directors, who must meet on a regular basis and approve the company’s major transactions. Some states impose additional requirements, fees, and taxes on S corporations.

Separate but Shared

An S corporation is usually treated as a separate entity from its shareholders. This means the shareholders generally cannot be held liable for the corporation’s debts (except in cases of misconduct). Shares can be exchanged between existing, new, or even deceased shareholders without disrupting operations or dividing the firm’s assets (the number of shareholders is limited to 100).

S corporations also may have access to attractive benefit plans, which could help remove some of the disadvantages of competing against larger corporations in the job market. Reorganizing as an S corporation could offer some appealing tax benefits, but it also has the potential to be time-consuming and expensive. Weighing the trade-offs may help you decide whether incorporating would be a smart move.

1) The New York Times, December 13, 2010
2) The Wall Street Journal, December 29, 2010

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