As a business venture grows, a sole owner of a business may choose to incorporate that business because of the advantages available to corporations. Unlike a sole proprietorship or a general partnership, corporations offer certain tax advantages, limit owner liability, and increase options for raising capital. The size and type of business help determine which type of corporation best suits the needs of that business. For many businesses, an S Corporation is the best option.
Basics of a Corporation
When creating a corporation, the first step is to file a certificate of formation with the Texas Secretary of State. By completing the paperwork, filing the certificate of formation on-line through SOSDirect, and creating the necessary corporate documents, a corporation meets the minimum state law requirements. Tex. Bus. Org. Code Ann. § 3.001. For more information, please visit our article entitled, Forming a Texas Corporation. By default, a corporation is a C Corporation for federal income tax purposes unless it makes an election to be an S corporation with the Internal Revenue Service.
Specifics of an S Corp
Once the corporation is approved by the state, filing a form with the IRS is the next step toward establishing an S Corp. Like other incorporated businesses, S Corporations offer protection to the company owners in the event of a lawsuit because the company is liable as opposed to the owners themselves. An important distinction between an S Corp and a C Corp, and a major benefit of electing S Corp status, is the fact that income and losses “pass through” to shareholders, allowing them to avoid double taxation.
S Corporations do have certain limitations, however. No more than 100 shareholders are permitted in an S Corp, making them best for smaller companies. Another limitation is that shareholders must be US citizens. Another consideration is that certain businesses, such as banks, credit unions, or insurance companies are not permitted to become S Corporations. Any business that makes 95% or more of its income from exports is also not permitted to file for S Corp status. S corporations are also prohibited from having classes of stock with different distribution rights. All distributions to shareholders in an S Corporation must be proportionate to the percentage of stock owned by each shareholder. Violating any of the above restrictions may cause an S Corporation to forfeit its S Corp status and immediately revert to a C Corporation.
The Texas LLC as an S Corp
Because an S Corp is a tax classification, a Limited Liability Company or LLC may elect S Corp or C Corp status. By default, the IRS classifies LLCs as disregarded entities or partnerships for tax purposes. Forming a Texas LLC and electing S Corp status for tax purposes is often the best decision for small business owners. The owners can benefit from the simplicity and ease of maintaining an LLC, achieve the same liability protection that a corporation provides, and operate as a pass-through entity for tax purposes, avoiding the double taxation of a C Corp.
While forms for creating Texas entities are available on-line, deciding what type of entity to form and tax status to elect are complex decisions. A lawyer knowledgeable in business law is an invaluable resource for evaluating the best possible decisions which might help a business to thrive.
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