According to the IRS, the S Corporation is the most frequently used business structure at 45.6 percent of all business entity returns filed in 2012 (latest available). An S Corporation is typically a corporation that is treated, for federal tax purposes, as a pass through entity. By electing to be treated as an S Corporation with the IRS, income is allowed to flow through the corporation without being taxed until it is claimed as income by the owners. This avoids the double taxation issue with the C Corporation where income is taxed on the corporation at the corporate rate, then again when it is distributed to the individual shareholders.
With an S Corporation, income is taxed once at the individual level and unlike the Limited Liability Company (LLC), the distribution is not subject to the Self Employment Tax of 15.3 percent. However, it should also be noted that some reasonable salary (inclusive of employment taxes) must be paid to the owner before a tax-free distribution can be made.
The requirement and benefit of an S Corporation can be illustrated in the example below.
S Corporation Distribution vs. Salary Cost-Benefit Analysis
The example below shows two scenarios comparing the tax consequences of an LLC vs S Corporation. Scenario 1 is a business with net income of $90,000 and Scenario 2 is a business showing $20,000. The example below shows the potential benefit from doing some tax planning and how changing income can change the cost-benefit analysis.
Scenario 1: $90,000 Net Income
As you can see above, in the LLC, you pay the Self Employment Tax on the full $90,000 distribution and then you pay the federal income taxes on top of that amount. In the S Corp, you pay the SE tax on the wages you pay yourself (remember our rule: one third of income or a $10,000 minimum salary), and then receive the remaining $60,000 distribution free of the SE Tax! This results in a lower effective overall tax rate of about 8.0%. Ahh yes, the beauty of the S Corporation. In the following example, we see how the benefit changes based on income of $20,000.
Scenario 2: $20,000 Net Income
Scenario 2 is similar to Scenario 1. The LLC pays no wages and receives the full $20,000 distribution. And the S Corporation pays the minimum salary of $10,000 since the one third of $20,000 falls below our minimum, and then pays the remaining $10,000 as a distribution.
Scenario 2 illustrates that even at lower levels of income where you pay yourself a minimum salary of $10,000, you can still save on taxes. As you can see, the net difference is a lower effective tax rate of nearly 7.0%. The question to ask yourself is, ‘Are the administrative burdens of setting up an S corporation worth 7.0% – 8.0% for me?’
If so, check out the detailed instructions on how to set up an S Corporation below.
How to Set Up an S Corporation
To set up an S Corporation for your business, you must first set up a separate entity, either an LLC or C Corporation. Because the previous section already covers how to set up an LLC, the following explains the process to set up a C Corporation prior to making an S Corporation election:
- Select state of operation. Similar to the LLC step above, you’ll need to select a state to register your Corporation.
- Choose a business name. Similar to the LLC steps above, you will need to select a unique business name. You will typically be required to include “Inc.” or “Corporation” after the name which indicates that your company is a Corporation.
- File the Articles of Incorporation with the state. Similar to the process for the LLC, a registration form will need to be filed with the state. For Corporations, states typically require statements about board of directors, shareholders, and outstanding shares in the registration. As a part of this step, you will need to identify the shareholders and determine what percentage of interest each shareholder will have in the business. Note that certain states (Arizona, Georgia, Nebraska, New York, and Pennsylvania) also require that you publish a notice of the incorporation.
- File Form 2553 with the IRS. Once your business is set up, you’ll next need to elect to be treated as an S Corporation using Form 2553, Election by a Small Business Corporation.
Once approved, you will receive Notice CP261, which is the approval notice for Form 2553. Once approved you’ll want to stay on top of filing requirements, which include filing of Form 1120S with the IRS each tax year. In addition, you’ll need to file a state S Corporation tax return, if applicable (check with your tax professional for state specifics).
The Benefits of an S Corporation
An S Corporation offers the following advantages:
Protects your personal assets. An S Corporation shareholder’s personal assets, such as personal bank accounts, can not be seized in order to satisfy the liabilities of a business. S Corporation shareholders receive the same liability protection as C Corporation shareholders. This protection is typically referred to as the “Corporate Veil.”
No “double taxation.” As a pass-through entity the majority of the business’s income and loss items are passed through to the shareholders so that they only pay taxes on the individual level for these items. There is no taxation at the corporate level with an S corporation in most states. However, in California, an S corporation’s income is taxable at the corporate level.
The ability to take income in the form of distributions not subject to Self Employment Taxes. S corporation shareholders can be considered as an employees of the business and draw salaries as employees. However, they are also permitted to receive dividends, as well as, other distributions that are tax free, helping them to reduce the burden of self-employment tax liabilities.
Easy transfer of interests. S corporation shareholders may transfer interests without triggering tax consequences.
Lower audit risk. As compared to Sole Proprietors, having your business run through an S Corporation is just smarter from an audit perspective as Sole Proprietors are three times as likely to be audited.
State Regulations for S Corporations
As a corporation, S Corporations are subject to state corporate requirements which include keeping minutes of board meetings, filing statements of information, and keeping updated Articles of Incorporation. You should also check with your state to find out about the specific regulations. In some states, S corporation status is not automatically granted simply because the IRS has approved S corporation status for your business.
While the certain states automatically grant S Corporation status to business who have elected federal S Corporation status, other states (such as New York) do not. Another issue that you should check on is whether your state taxes distributions (double taxation). Certain states, including California and New York, tax S corporation distributions albeit at low levels.
What This All Means
- A separate business entity provides business owners with two minimum essential benefits: (1) personal liability protection and (2) a statistically lower chance of getting audited.
- LLCs provide a low-cost, low-administrative burden way to incorporate for single members.
- S Corporations can provide a significant tax benefits, even with net profits of as low as $20,000.
- LLC’s can elect to be treated as S Corporations later, so even if you’re committed to the LLC benefits, you don’t indefinitely lose the perks of an S Corporation because you can always make the election later.
We hope you’ve enjoyed this post. Keep an eye out for more business-focused tax and accounting content on our blog: https://mytaxhack.com/blog/.
Please note: This blog is for informational purposes only. Be advised that business taxation rules and laws are subject to change at any time. For specific tax advice regarding your business, contact us.