Since the passing of the Tax Cuts and Jobs Act of 2017, there have been many questions and concerns involving S Corporations. Due to its complexity, it’s important to start with the basics. We’ve created a user’s guide to S Corporations that’s designed to help ease confusion amongst business owners. What is an S Corp? What are some S Corp advantages? Here’s your chance to find out!
What Is an S Corp?
S Corporations, otherwise known as S Corps, begin as Limited Liability Companies (LLCs) or corporations. Owners of the LLCs or corporations have the ability to elect to file under subsections of the tax code, most commonly referred to as subsection “C” or “S.” Once chosen, companies are known as C Corporation/C Corps and S Corporations/S Corps, respectively.
C Corps and S Corps have a lot in common. Both need to be set up with the state and require a filing fee. Their shareholders are not usually held liable and their businesses must hold annual meetings with a board of directors. The main allure of becoming an S Corp is the fact that businesses can avoid double taxation.
Double Taxation & Why it Matters for S Corps
Every business pays taxes on the profits it accumulates. C Corps pay federal, state, and self-employment tax, which includes Social Security and Medicare tax. In comparison, S Corporations forego paying the self-employment tax. Instead, they let the business’s profits, losses, deductions, and credits pass-through to the shareholders and owners.
Note: All employees of S Corps must be paid a salary, including shareholders and owners. Owners must have “reasonable compensation” as pay to avoid issues with the IRS. In addition, business owners will still need to pay their individual income taxes.
Once the business’s profits have passed through to the shareholders and owners, the smaller portion of individual income is taxed as normal (federal, state, and self-employment tax). This is what entices business owners to elect to become S Corps. By being taxed on an individual level rather than a corporate level, owner’s have the potential to save money on taxes.
C Corporation & S Corporation Tax Rates and Brackets
Overview of C Corporation Taxation
Due to the Tax Cuts and Jobs Act, the tax rate for C Corporations has been reduced from 35% to 21%. This means that the business will be taxed at 21%, and then any dividends will be taxed individually on owner/shareholder personal tax returns.
Example: You are the owner of your business that has a profit of $100,000. You’d pay 21% ($21,000) in corporation taxes, leaving you with a dividend of $79,000. That amount would then be subject to personal income tax. For this example, the personal income tax would be 22%. Twenty-two percent of $79,000 is $17,380, so you’d be left with $61,620 after taxes.
Overview of S Corporation Taxation
S Corporations are taxed at the shareholder rate on personal returns with a 20% deduction on income from the pass-through entity.
Example: Like the C Corp example, you are the owner of your business that has a profit of $100,000. Twenty percent of would be deducted, leaving you with $80,000. The $80,000 passes through to your personal account as income and is taxed on your return at 22%. Twenty-two percent of $80,000 is $17,600, so you’d be left with $62,400, which is more than what you’d be left with as a C Corp.
What Are the S Corp Requirements?
According to the IRS, a business must meet a certain number of requirements to have the ability to elect to become an S Corp. A business must:
- Be based in the United States and have filed as such.
- Maintain 100 shareholders or less that are considered individuals, trusts, and/or estates.
- Have no more than one class of stock.
- Not be a financial institution, insurance company, or domestic international sales company.
What Are The Benefits & Drawbacks of S Corporations?
When it comes to deciding whether or not to switch to an S Corp, businesses should think about the pros and cons. We’ve listed them out for you to make it easier to decide what would work best for your business.
Top S Corporation Advantages
- A level of taxation is eliminated so company profits are only taxed once, not twice. This helps cut down on the amount of tax paid overall.
- Pass-through taxation allows owners to report their share of profit and loss on their own personal tax returns. This works in tandem with the single level of taxation. Instead of having the large company profit become taxed as a whole, smaller amounts are taxed on personal tax returns. Overall, this means less tax is owed.
- With an S Corp, the business can survive past the owner’s retirement and/or death. It can live on as long as someone is running it.
- Shareholders of S Corps have liability protection, which means they are not responsible for the debt of the business. This is great leverage for investors.
- S Corps only have to file taxes annually rather than quarterly as C Corps do.
Top S Corporation Disadvantages
- S Corps need accounting and bookkeeping specialists to accurately determine salaries, distributions, and taxes. They will also have to ensure the payroll system is working appropriately.
- They must follow certain requirements such as coordinating reoccurring meetings for board directors and shareholders. All meetings must be recorded in detailed minutes for reference.
- S Corps aren’t an investment that will appreciate over time. Any profit on the sale of the business will be taxed higher than other business tax models.
- Owners and shareholders that own 2% or more of the company can’t receive tax-free benefits.
- If the tax status of an S Corp is compromised at any time, the IRS has the ability to charge back-taxes for three years and impose a five-year waiting period to reclaim tax subsection “S.”
- C Corps can own shares of stock to increase capital. Those stocks can also be transferred easily. In comparison, S Corps have limitations on stock ownership and stock transfers can be hindered by IRS regulations.
Making the Final Decision
In general, S Corps tend to be small businesses, while C Corps are usually larger businesses. However, every company is different. Due to the number of factors each business has to consider when choosing to become a C Corp or an S Corp, it’s best to consult a professional before making any decisions. In the meantime, you can check out some of these valuable S Corp resources!
“What Is an S Corp?” Video
This video reviews the basics of S Corps in just over two and a half minutes. The graphics allow you to follow along, making it great for visual learners to fully understand the complicated topic.
S Corp Savings Calculator
This helpful calculator allows you to estimate the amount of tax savings you can accrue by switching to an S Corp. While the estimate may not be as accurate as what a tax professional would come up with, it will give you a general idea of how much you could truly save every year.