Start a New York S Corp

Pros and Cons of Filing as an S Corp

While S corporation classification does come with benefits for some businesses, making this election might not be right for every company. Carefully weigh the pros and cons before deciding how you want to move forward. Consult a tax professional about whether the S corporation election would be best for your business.

Advantages of S Corp Status for LLCs

The advantages of filing as an S corporation for an LLC differ from the advantages for C corporations. Let’s look at the advantages for LLCs first.

By default, 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 Tax 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 the profits received from the LLC. This is more than the taxes they’d pay for Social Security and Medicare when working for someone else because their employer would pay part of them.

Two Sources of Income

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 of the LLC. 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 must still pay state and federal taxes 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

One caveat to this arrangement 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 $5 and avoid contributing anything to your Social Security and Medicare. 

But what is “reasonable compensation” to the IRS? 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 completely defined, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning for the same work.

If the IRS determines that your salary isn’t reasonable, it has the authority to reclassify your non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases have supported their right to do this.

Disadvantages of S Corp Status for LLCs

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

Stricter Requirements 

As we listed above, S corps have more qualifications to meet than a standard LLC. An S corp can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. 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 keeping a corporate records book), even if they’re not legally required to so that they’ll be more prepared in the event of an audit.

Additional Accounting and Bookkeeping

Having an S corporation 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 start doing so. Your taxes will be more complex, as well.

These added complications could mean that you’ll have higher administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software.

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, the profits are taxed a second time on the shareholders’ personal tax returns.

But when a C corporation qualifies to be an S corp, those profits are usually only taxed at the individual level, at least for federal income tax. The business itself usually 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.

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 once 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 corporation 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.

QBI Deduction

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

Disadvantages of S Corp Status for C Corporations

S corporation status also has its downsides:

Limited Number of Shareholders

As we mentioned, 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 or corporations as shareholders. C corporations don’t have these limitations.

One Class of Stock

Corporations sometimes attract investors by offering 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, the IRS watches corporations with S corp election 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, and they may also be able to help you find additional tax savings you were unaware of.

New York-Specific Considerations

In an S corp, the business itself doesn’t usually pay federal income taxes. But what about state income taxes?

The State of New York does not automatically treat your company as an S corporation for state tax purposes. To make the New York S corporation election, you’ll need to file Form CT-6, Election by a Federal S Corporation to be Treated as a New York S Corporation. But before you do that, you need to make sure that you meet the following requirements:

• Be a federal S corporation.
• Be a general business corporation taxable under Article 9-A or be the parent of a qualified subchapter S subsidiary (QSSS) that is taxable under Article 9-A of the New York State Tax Law. Insurance corporations taxable under Article 33 or any corporation taxable under Article 9 can’t elect to be a New York S corporation.
• Get consent from all of the corporation’s shareholders for making the New York S election. You’ll need to list all of them on Form CT-6 and include their signatures.

Even if they make the New York S corporation election, S corps are still responsible for paying the state’s corporation franchise tax. The business pays a fixed dollar minimum tax based on New York receipts.

New York City

If your business is in New York City, note that the city doesn’t recognize federal or New York S corp elections. New York City has a general corporation tax (GCT) that all domestic and foreign S corporations and qualified S subsidiaries must pay if they’re doing any of the following in the city:

• Doing business;
• Employing capital;
• Owning or leasing property, in a corporate or organized capacity; or
• Maintaining an office.

However, the following kinds of S corporations are exempt from the general corporation tax, including:

• Dormant S corporations that did not engage in any business activity or hold title to real property located in New York City
• S corporations subject to tax under the banking corporation tax
• S corporations subject to the utility tax, except vendors of utility services that are subject to the GCT
• S corporations organized to hold title to property as described in sections 501(c)(2) or (25) of the Internal Revenue Code
• Insurance corporations
• Non-stock, not-for-profit companies that are granted an exemption by the New York City Department of Finance
• Limited-profit housing and housing development fund companies organized and operating under Articles 2 and 11, respectively, of the Private Housing Finance Law

The good news for New York City S corporations is that they’re exempt from the city’s Business Corporate Tax.

We can help

Setting up an S corp in NY can be challenging, but we’re here to make it as easy for you as possible.

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