Running an S corp is a great way for business owners to enjoy certain tax benefits and protect their personal assets. However, when it comes to qualifying for a mortgage, owning an S corp can add complexity to the process.
Unlike a sole proprietorship or partnership, an S corp is a separate legal entity, which means mortgage lenders may require additional documentation when evaluating your eligibility. Keep reading to learn more about an S corp and qualifying for a mortgage.
What is an S Corp?
An S corp is a business entity allowed to pass its income, deductions, credits, and losses directly to its shareholders. Simply put, S corps are exempt from federal income tax. For this reason, they’re sometimes referred to as “pass-through entities.”
Shareholders of S corporations are responsible for reporting income and losses in their personal tax returns, evaluated at their individual income tax rates. S corps are restricted to 100 shareholders who can hold stock. Besides, these shareholders can’t be corporations, partnerships, or non-residents.
How Does an S Corp Differ from Other Types of Business Entities?
An S corp differs significantly from other types of business entities.
C Corp
Like an S corp, C corp gets its name from subchapter C of the Internal Revenue Code. The main difference between a C corp and an S corp lies in federal taxation. C corps are subject to double taxation. Corporate income tax from a C corp is first taxed when earned, then passed to shareholders who pay their personal taxes on the dividends they receive.
While a C corps has double taxation, there’s no limit on the number of shareholders who can own the stock and can include businesses and entities within the country and overseas. This means the company can raise capital through the sale of shares.
LLC
A limited liability company (LLC) is one of the most flexible types of business entities. LLC owners (called members) benefit from the limited liability status, which protects them from being personally liable for business debts and liabilities.
LLCs combine both aspects of partnerships and corporations. They can choose how they want to be taxed 一 either as an S corp or a C corp if it meets specific requirements.
Many small business owners establish an LLC because of its flexibility and protection to its members and later elect the S corp status instead of registering as a corporation.
Sole Proprietorships
A sole proprietorship is an unincorporated company owned by one individual. It’s easy to establish as it doesn’t have government regulations. For this reason, sole proprietorships are common among individual business owners, consultants, and sole contractors.
Although it’s the most straightforward type of business to establish, it doesn’t offer legal protection to the sole proprietor. Unlike partnerships and corporations, sole proprietorships don’t create a separate legal entity for the business. As such, the owner is fully responsible for all the liabilities incurred by the entity.
Partnerships
Partnerships are exactly what it sounds like 一 owned by two or more people called partners. Like sole proprietorships, they have similar liability and tax aspects. Partnerships must report their annual income, losses, deductions, and credit but don’t pay income tax. Instead, it passes through to the partners.
For example, a partner of a general partnership is liable for the company’s liabilities. At the same time, the partner must report their income, credits, profits, and losses on their personal tax return. Besides, partners must pay self-employment tax where applicable.
Facts About Running an S Corp
Establishing an S corp can be an exciting and complex process. From registering your business to electing the S-corp status, a lot must be considered. Here are the top five facts you need to know about running an S corp before taking the plunge.
1. Starting the Business
Running an S corp is not as difficult as it might seem. The first step to starting an S corp is filing the Articles of Incorporation with the state and paying any filing fees. After incorporation, you must complete Form 2253 with the IRS to elect the S corporation status.
Here are the steps to electing your S corp status:
- Form your LLC or corporation: If you don’t have a legal business entity, you’ll need to register with your state’s business formation agency either as an LLC or corporation.
- Get a federal tax ID number: Before you elect S corp status, you need to get a federal tax ID number, also referred to as EIN, FEIN, or Tax ID.
- Ensure your existing LLC or corporation meets the requirements: To elect S corp status, your LLC or corporation must have no more than 100 shareholders. The shareholders must not be partnerships, corporations, or non-residents.
- File the paperwork: If you meet the requirements set forth by the IRS, fill out Form 2253 to elect your S corp status.
- Maintain the requirements: After claiming your S corp status, ensure your business continues to meet the requirements for shareholders and stock.
2. Shareholder Rights
As a shareholder of an S corp, you have rights, including:
- Disbursements: You have a right to receive a share of the entity’s income, losses, credits, and deductions, called disbursements. You’ll find these figures in your IRS Form K-1. While your right to pass-through income relieves the corporation from federal taxes, sharing company losses gives you the right to deductions in the future when profits skyrocket.
- Participations: As a shareholder in an S corp, you enjoy more corporate governance because the law limits up to 100 shareholders. Plus, your rights aren’t limited by the type of stock because S corps only issue one class of stock. The number of shares you own impacts your power in voting for directors, receiving disbursements, and adopting by-law amendments.
- Considerations: You can also enjoy similar rights as shareholders of a C corp when you buy stock. For instance, you can attend meetings, vote for directors, and inspect the books. Besides, you also have the right to sue the board of directors for “unwarranted acts,” such as fraud and misinterpretation.
3. Taxes
S corps don’t pay corporate income taxes. Instead, the company’s shareholders split the profits and losses and report on their personal tax returns. These figures are recorded on Schedule K-1 (Form 1120-S).
As a shareholder of an S corp, you can deduct up to 20% of your qualified business income (QBI). However, some companies, such as accounting and law firms, don’t qualify for the pass-through deduction. This deduction is in addition to the standard business expenses deductions the S corp can use to reduce its taxes.
S corporations must also pay employment and unemployment taxes, FICA (social security and medicare), withholding and reporting federal and state income taxes, and employee’s compensation taxes.
To elect as an S corp, your business must be first registered as a regular C corporation or have filled the LLC status. Keep in mind that you can’t incorporate an S corp because the status is tax designation.
If you’re electing an S corp as a C corp, you must submit IRS Form 2253. All the shareholders must sign the form as a way of agreeing to the election and disclosing the number of shares owned.
4. Ownership
S corps have strict limits around shareholders. This type of business entity can have no more than 100 shareholders. Plus, it’s restricted to individuals who must be citizens or permanent residents of the U.S.
However, specific trusts, estates, and tax-exempt organizations can hold the stock. Partnerships, corporations, and non-residents can’t be shareholders of an S corp.
5. Pros and Cons
Pros
- Pass-through taxation: An S corp comes with several tax benefits. One key advantage of an S corp is its pass-through taxation. The taxes are passed to the company’s shareholders, who report on their personal tax returns.
- Independent life: Unlike an LLC or a sole proprietorship whose business life depends on the owners, an S corp has a separate life from the shareholders. Its life span is not dependent on the shareholders, making it easy to operate.
- Easy transfer of ownership: It’s relatively easy to transfer your ownership interest in an S corp compared to other business entities. You can transfer your shares to another corporation in two ways 一 an outright sale or a gradual sale 一 without going through a lengthy process.
- Shareholder protection: The structure of an S corp offers shareholder protection. No shareholder is personally liable for the obligations of the business. Even if the company is sued or can’t pay its debts, your personal assets won’t be at risk.
- Lower self-employment tax: An S corp structure can help reduce self-employment tax. If you’re the sole business owner, you must pay both income and self-employment taxes. However, with an S corp, you can classify your income as either salary or distribution. Here, only the salary attracts the self-employment tax, reducing your tax liability.
- Enhanced credibility: Another benefit of establishing an S corp is enhanced credibility. The business structure of an S corp is highly credible among potential customers, vendors, and partners. This can help you win more clients and retain existing ones.
Cons
- Protocols: To establish an S corp, you must follow several protocols, including meeting minutes, maintaining proper records, scheduling meetings of directors and shareholders, and much more.
- Strict shareholder requirements: The IRS has laid down strict qualifications for the S corp status. An S corp can have no more than 100 shareholders; all must be U.S. citizens or permanent residents. Even during the transfer of ownership, you can only transfer to specific individuals, estates, or trusts.
- Increased scrutiny from the IRS: The IRS is closely monitoring S corps, especially on compensation requirements.
Can an S Corp Qualify for a Mortgage?
Yes, an S Corp can qualify for a mortgage, but the application process might be complex since they’re considered self-employed borrowers.
As a self-employed borrower, you must prove to lenders that your business is creditworthy. As such, you’ll need to provide financial statements, tax returns, and other documentation lenders use to evaluate borrowers’ eligibility.
How Can an S Corp Apply for a Mortgage?
If you run an S corp, applying for a mortgage can seem challenging because of the complex nature of the business structure. However, the mortgage application process is similar to that of an individual but with extra steps.
As an S corp owner, you must establish your creditworthiness, typically by providing your financial history. This includes business tax forms, financial statements, and credit reports. Additionally, you may need to provide personal guarantees from the company owners.
If you meet the lender’s requirements, you’ll likely get approved for a mortgage loan.
