Start an Indiana S Corp

Indiana S Corporation: Pros and Cons

While S corp classification comes with tax benefits for some businesses, making this election might not be right for every company. Have a chat with an experienced tax professional and carefully weigh the various pros and cons before deciding how you want to move forward. 

Indiana S Corporation: Advantages for LLCs

The advantages of filing as an S corporation for an LLC aren’t the same as they are for C corporations. Let’s first examine the advantages for LLCs.

A traditional LLC already has pass-through taxation by default, so the benefits of federal S corporation election for an LLC have to do with the taxes for self-employment. This does take some explanation, but it could save certain LLCs a lot in those taxes.

Explaining Self-Employment Tax

The members of a regular LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC, meaning that they’re self-employed.

Being self-employed means you pay self-employment taxes (Social Security and Medicare, which add up to about 15.3%) on all the profits you receive from the LLC. That’s more than the taxes you’d pay when working for someone else because your employer would pay part of them.

Dividing Profits and Salary

But when the members file for S corporation election, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay Social Security and Medicare taxes on their salary and not the profits they receive. Depending on factors such as how profitable your company is, the savings could add up to a lot. (Of course, the members will still pay income and all other applicable taxes on their share of the profits.) Money paid out as salary is also a tax-deductible expense for the business. 

Reasonable Compensation

An important stipulation to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. If not for that requirement, you could pay yourself an annual salary of $7 and avoid contributing anything to Social Security and Medicare. 

So, how does the IRS define “reasonable compensation”? The instructions on Form 1120-S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” While the terms aren’t precisely defined, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning.

If the Internal Revenue Service determines that whatever salary you’re paying yourself isn’t enough, it has the authority to reclassify your non-wage distributions (which aren’t subject to employment taxes) to wages (which are subject to employment taxes). Court cases have supported the IRS’s right to do this.

Disadvantages of S Corporation Election for LLCs

Choosing S corporation status for your LLC can also have some drawbacks over a standard LLC:

Stricter Requirements 

S corporations have more conditions to meet than a standard LLC or corporation (as we listed above). S corp filing requirements say that you can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A standard LLC doesn’t have these limitations.

More Scrutiny from the IRS

The IRS usually monitors LLCs filing as S corps more closely because of the above restrictions and the requirements about paying yourself a reasonable salary. That could mean a greater chance of being audited, even if you follow the law to the letter.

In fact, small business owners in an S corporation may want to observe some of the same formalities that corporations do (such as extensive record keeping), even if they’re not legally required to. It’s not necessary to appoint corporate officers or write corporate bylaws, but keeping something similar to a corporate records book could be useful if the business is audited.

More Bookkeeping and Accounting

Having an LLC with an S corporation election generally means more paperwork. If you don’t already have to do payroll for your business, being an owner-employee means that you’ll have to do so. Your taxes will be more complex, too.

These added complications could mean that you’ll have higher administrative costs because you may need to pay for payroll and accounting services.

Indiana S Corp: Advantages for C Corporations

If you have a C corp (the default form of corporation), filing as an S corporation has these advantages:

Pass-Through Taxation

Traditional corporations have to deal with “double taxation.” When the corporation makes money, the IRS taxes those profits on the corporate level. But when those profits are ‌distributed to the individual shareholders as dividends, they’re taxed a second time on the shareholders’ personal tax returns.

But when a corporation qualifies to be an S corporation, those profits are only taxed at the individual shareholder level. The business itself isn’t taxed on them. This is called “pass-through taxation,” and it’s how business entities like sole proprietorships and general partnerships are taxed. LLCs are also taxed this way unless they choose to be taxed as a corporation.

However, since the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to a flat 21%. So, the disadvantages of double taxation aren’t as much now as they were. 

Writing Off Losses

Just as company profits pass through to the owners of an S corporation, so do the losses. Unlike the shareholders of a C corp, S corporation shareholders can write off the company’s losses on their personal income statements. 

This can help offset their income from other sources and can help if the corporation loses money in its early years. However, make sure you’re aware of and understand ​​the IRS’s shareholder loss limitations.

Qualified Business Income Deduction

Under the 2017 Tax Cuts and Jobs Act, some S corporation owners may be able to deduct up to 20% of their qualified business income (QBI). This deduction isn’t available to C corp shareholders.

QBI is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.” The IRS website has a detailed explanation as to what is and is not included in QBI. There’s an income threshold that, if exceeded, may reduce your QBI (see the IRS website for details).  

S Corp Indiana: Disadvantages for C Corporations

S corporation election also has the following minuses:

Limited Number of Shareholders

As mentioned, an S corporation can’t have more than 100 shareholders, while a C corporation doesn’t have that restriction. This limitation could be an issue later if the corporation expands and goes public.

Limited Types of Shareholders

All S corp shareholders must be U.S. citizens, or certain trusts or estates. That could become a problem if you want to expand internationally. You also can’t have partnerships or corporations as shareholders. Standard corporations don’t have these restrictions.

Only One Class of Stock

A common way corporations attract investors is to offer preferred stock. C corporations can legally do this, but the IRS doesn’t allow it for S corporations.

More IRS Scrutiny

As with LLCs, the extra restrictions S corps often cause the IRS to watch them more closely to see if they’re in compliance. In other words, your corporation’s more likely to get audited.

We can’t stress enough how important it is to have tax guidance about your specific situation from a qualified tax professional. An accountant with S corporation knowledge should be able to make sure you stay in compliance with the IRS. They may also be able to help you find additional ways to lower your tax bill.

Considerations for Indiana S Corporations

In an S corporation, the business itself doesn’t usually pay federal income taxes; the individual owners pay personal income tax on the profits. But what about Indiana state income taxes?

Indiana treats businesses that file as an S corp for federal income tax purposes the same way when it comes to income tax from the state. That is, the same pass-through taxation that applies to federal income taxes applies to state income taxes. So, you shouldn’t have to worry about a separate Indiana S corp tax rate.

However, any S corporation doing business in Indiana and deriving gross income from sources within Indiana must file an annual Indiana S corp return, Form IT-20S, and the information return IN K-1 with the Indiana Department of Revenue, disclosing each shareholder’s share of distributed and undistributed income.

Some states require an S corporation to make a separate S corporation election at the state level, but Indiana doesn’t require that. If a company has a valid federal subchapter S corporation election, it will automatically become an Indiana S corporation.

We can help

Forming a Hoosier business with or without S corporation election can be complicated, but we’re here to make it easier. We can help you form an Indiana LLC with an S corporation designation and provide you with Indiana business resources and valuable support from our team of business experts. Contact us today to get started.