Start a Michigan S Corp

Requirements and Limitations of S Corporations

There are a few Michigan S corp filing requirements and limitations you should be aware of. Specifically, to qualify for S corporation status, an entity must:

• Be a domestic corporation or LLC
• Have only allowable shareholders or members, such as individuals, certain trusts, and estates
• Have no more than 100 shareholders or members
• Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
• Have only one class of stock

Not all business entities are eligible for S corp classification. However, if your business entity meets these requirements, you can apply for an S corp election. 

Pros and Cons of Filing as an S Corp

While S corp classification does come with a number of benefits for some businesses, making this election might not be right for all business types. So, be sure to carefully weigh the various pros and cons before deciding how you want to move forward. 

Advantages of S Corp Status for LLCs

The advantages of filing as an S corp for an LLC aren’t exactly the same as they are for C corporations. Let’s look at the advantages for LLCs first.

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

Self-Employment Taxes Explained

The members of a standard 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. Being self-employed means paying self-employment taxes (Social Security and Medicare, which adds up to about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay part of them.

Dividing Salary and Profits

But when the members elect S corp status, 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 a tax-deductible expense for the business. 

One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. The IRS considers “reasonable” to be something similar to what others in your field are earning.

Disadvantages of S Corp Status for LLCs

Having an LLC with S corp status can have some drawbacks over a traditional LLC:

More Filing Requirements 

As we listed above, S corps must adhere to more regulations than a standard LLC or C corporation. All the members must be U.S. citizens (which can also include certain trusts and estates), and there can be no more than 100 of them. A traditional LLC doesn’t have these limitations.

More IRS Scrutiny

Because of the above restrictions and the requirements about paying yourself a “reasonable salary,” the IRS tends to monitor LLCs filing as S corps more closely. That could mean a greater chance of being audited, even if you follow the law to the letter. In fact, S corp owners may want to observe many of the same formalities that C corporations do (such as regular meetings and extensive record keeping), even if they’re not legally required to.

Advantages of S Corp Status for C Corporations

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

Pass-Through Taxation

One big disadvantage for traditional corporations is “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 owners (shareholders) as dividends, they’re taxed a second time on the shareholders’ personal tax returns.

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

We need to add here that, 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 severe now as they were. 

Writing Off Losses

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

This can help offset their income from other sources and can be helpful if the corporation loses money in the first couple of years. Still, make sure you’re aware of ​​the IRS’s shareholder loss limitations.

Qualified Business Income Deduction

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

Qualified business income (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).  

Disadvantages of S Corp Status for C Corporations

S corp status also has its downsides:

Limited Number of Shareholders

As we said, an S corp can’t have more than 100 shareholders, while a C corporation has no such restriction. That 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 limit your ability to expand internationally. You also can’t have partnerships, corporations, or non-resident aliens as shareholders. C corporations don’t have these limitations.

One Class of Stock

One way corporations attract investors is to offer preferred stock. That’s fine for C corporations, but the IRS doesn’t allow it for S corps.

More IRS Scrutiny

Because of the extra restrictions S corps have, the IRS watches them more closely to see if they’re in compliance. In other words, your corporation is 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 corp experience should be able to make sure you stay in compliance with the IRS, but they may also be able to help you find additional tax savings.

We can help

Forming a business can be complicated, but we’re here to make it as stress-free for you as possible.

When you’re ready to take the leap, we can help you form a Michigan LLC with an S corporation designation and provide you with valuable support for all of your business needs moving forward. Contact us now to get started.