The primary feature which attracts most small business owners to structure their business as an S Corporation is the significant tax savings on the passive income which is not subject to FICA taxes i.e. Social Security and Medicare Tax, which is currently 15.3% and is expected to rise in future years.
Here is how the process works. As an owner aka shareholder, you will pay income tax on the profits generated by the S Corporation. This tax will depend on your Marginal Tax Bracket or tax rate. The tax bracket can range from 10%-45%. Because you will be involved in the business, you must be compensated with a reasonable salary as an employee. So you will have two types income: salary and corporate profits that you can distribute to yourself or leave it in the corporation. Basically as an owner of the corporation you are entitled to take money that the corporation produced. The great thing about the corporate profit distributions is that it’s not subject to Social Security/Medicare Tax because IRS views this type of income as passive.
An additional factor which makes S Corporations attractive is the fact that business losses can be deducted on the owner’s individual tax return, which is not the case for C Corporations. This is particularly attractive for new start-up companies with high start-up expenses. It is important to note, however, that there are limitations to the amount of losses that you can use. Each taxpayer has his unique tax situation so you should talk to your CPA or Tax Accountant to find out about those limitations and how they apply to you.
Since an S Corporation is a flow through entity, all income/losses incurred by the S Corporation flows straight through to the shareholders. On the federal level (and in most states, on the state level) the S Corporation is not subject to corporate tax, so it avoids the double taxation that C Corporations are well known for. The downside of the flow through entity treatment is that the owners of the S Corporation are responsible to pay taxes on all corporate profits, even if those profits were not distributed to the owners.
It is important to consult with your CPA or Tax Accountant as to whether or not the flow through treatment that an S Corporation provides is advantageous or disadvantageous to your particular situation. Escaping the corporate tax through the flow-through tax treatment can either increase or decrease your tax liability. It is important to take into account the effects that your business income might have on pushing up your individual tax bracket.
For example: David and Sally earn $50,000 per year and were in the 15% individual Federal tax bracket. When they formed their S Corporation, their business earned $40,000 in profits, but since the entire business profit flowed-through to their individual tax return, their income increase thus their tax bracket went up to 25%. Had they formed their business as a C Corporation instead, they would remain in the 15% bracket on the individual level, and be responsible for the 15% tax on the corporate level. The C Corporation would then distribute the profits to them in the form of qualified dividends that will not be subject to tax because they were on a 15% individual tax bracket in 2012. As a result of good tax planning they both saved on taxes.
Despite all of the potential tax saving advantages that the S Corporation can offer, there are a few other factors that one should consider before deciding to form an S Corporation. Firstly, there are additional expenses involved with the formation of the business, as compared to a partnership/LLC. The S Corporation is required to file quarterly payroll tax returns, which means that the costs of maintaining the S Corporation are higher than the costs of maintaining an LLC. Also, S Corporations are subject to strict regulations which they are expected to follow. For example, an S Corporation must have a Board of Directors, maintain records of board meeting minutes, have annual reports, create business filings, and be subject to regulatory compliance.
An S Corporation is less flexible than an LLC in terms of income/loss allocation. Whereas the members of an LLC can pick and chose how much income or loss each member is allocated with on their individual returns, in an S Corporation, income/loss allocation is strictly proportional to their percentage ownership in the corporation.
Finally, liabilities, like mortgage and other qualified debt, are not included in each shareholder’s basis (capital) in an S Corporation. This is important because each shareholder’s losses are limited to the amount of basis that they have in the company. Therefore, using an S Corporation for businesses like real estate, where investors typically take out a large mortgage on the property, would not be advisable.
There are a few important guidelines that you must keep in mind in order to make sure that your business will qualify as an S Corporation. Firstly, your business must be a domestic corporation i.e. formed in the United States. Furthermore, all shareholders of the S Corporation must be either citizens or legal residents of the United States. An S Corporation in limited to a maximum of 100 shareholders. The S Corporation can only issue one class of stock. Finally, an S Corporation can only be owned by individuals, estates, Single Member LLC and certain trusts and tax-exempt organizations. That means that partnerships, corporations and most LLC’s are not eligible to be part owners of S Corporations. If you meet these guidelines, forming your business as an S Corporation has potential to create significant tax savings opportunities for your business.
This article was written by TaxBizPro, LLC 2012, all rights reserved ©.