A Breakdown of the Tax Implications of an S Corporation
When it’s time to think about the best business structure for your company, taxes shouldn’t be the only factor. After all, you are going to want to think about all the aspects, such as liability protection, ownership allocation and the amount of paperwork and administrative obligations.
However, taxes are usually front and center in people’s minds, as no one wants to pay more taxes than they need to. So below I'll outline the tax impact of the S corporation to see if it’s the best structure for your new or existing business. Keep in mind that this is general information and sometimes it’s best to seek expert tax advice pertaining to your particular situation.
The main difference between a C corporation and S corporation
Income earned by a C corporation is typically taxed at corporate income tax rates. Then, after the corporate income tax is paid, any distributions made to stockholders are taxed again as dividends on the stockholders’ personal tax returns. This is called “double taxation” since corporate profits are first taxed on the corporation and then dividends are reported on the individual stockholder’s return.
When a corporation elects “S corporation” treatment, it no longer has to pay taxes on the profits. Instead, all profits are passed through to the stockholders, and each stockholder needs to report their share of the corporation’s profits or losses on their personal tax return.
Let’s say you own 40 percent of a corporation that elects S corporation tax treatment. If the company makes $100,000 in profit for the year, you will be responsible for paying taxes on $40,000.
A term such as “double taxation” sounds like something that should be avoided in all circumstances. However, careful tax planning can minimize the downside. For example, when the top individual tax rate is higher than the top corporate rate, it can be preferable to have more money taxed at the corporate rate than individual rate. And if you plan on keeping profits in the business (and not passing them out to stockholders), the regular C corporation might be better tax wise.
A potential S corporation hiccup: ownership allocation
Any business owner considering the S corporation needs to keep in mind that all profits and losses pass through strictly based on a shareholder’s percentage of stock ownership. If you own 40 percent of the stock, you must take 40 percent of the losses, profits and credits on your tax return.
This is an important difference between an S corporation and a partnership or limited liability company (LLC). In partnerships or LLCs, the operating agreement can define the percentage that each partner or member should be taxed. For example, you might own 40 percent of the business, but did the bulk of the work one year and it’s decided that you should take home 60 percent of the profits. An LLC or partnership gives you this flexibility for reporting income on your taxes.
Can an LLC elect “S corporation” tax treatment?
When a corporation elects S corporation status, it’s still treated like a regular corporation in all aspects except taxes. This means a high level of paperwork and legal obligations -- and these can be too onerous for some smaller businesses. By contrast, the LLC requires fewer forms for registering and you’re not required to have formal meetings and keep minutes.
One option is to form an LLC and request S corporation status for the business. The company remains an LLC from a legal standpoint, but is treated as an S corporation for tax purposes. One advantage here is that S corporation status gives you the option to divide up the company’s earnings into salaries and then passive income in the form of distributions. Salaries are subject to FICA tax (social security and Medicare), but the distributions are not. Again, a tax advisor can help you determine if this configuration is right for your situation.
The upcoming S corporation deadline
To elect S corporation tax treatment, you need to file Form 2553 with the IRS. This paperwork is time-sensitive. For brand new companies, you need to file it before the first two months and 15 days for it to take effect for the current tax year.
Existing companies need to file their paperwork within the first two months and 15 days since the beginning of their tax year. If you have an existing company and you want S corporation tax treatment for tax year 2015 (assuming you report on the calendar year), then you will need to get Form 2553 in by March 16. To qualify, your business can only have one class of stock, have no more than 100 shareholders, and all shareholders must be U.S. residents.
Take some time to consider if S corporation status is right for your business, and be sure to get your paperwork in on time to take advantage for tax year 2015.