The “S” in “S Corporation” refers to Subchapter S of Chapter 1 of the Internal Revenue Code. Similarly, the “C” in “C Corporation” refers to Subchapter C.
C Corporations are businesses that are distinct taxable entities. When they receive income, they pay taxes on that income at the corporate rate and whatever is leftover belongs to the C Corporation. The owner(s) of a C Corporation receive pay
outs in the form of dividends, that the owner(s) pay taxes on at their personal rate(s). This is called double taxation. Virtually every other type of business has “pass-through” taxation. With pass-through entities (e.g., sole proprietorships,
partnerships, and LLCs taxed as either), the profits and losses pass through the business to its owner(s). The business itself does not pay taxes on that income. This pass-through usually results in some substantial tax savings.
An S Corporation is a C Corporation with pass-through taxation and some additional limitations. The profits and losses of an S Corporation pass right through to its owners — the S Corporation itself isn’t subject to income tax.
One of the biggest reasons a business owner chooses to form an S Corporation (or an LLC taxed as one) is the owners of an S Corporation do not pay self-employment taxes. Owners of sole proprietorships, partnerships, or LLCs taxed as either, cannot employ an owner in the traditional sense. When the company receives taxable income, it passes through to the owner and the owner must pay income tax and self-employment tax on the amount received. Self-employment tax consists of both the employer’s and employee’s portion of taxes for Social Security (12.4% of the first $132,900 of a taxpayer’s wages, tips, and net earnings) and Medicare (2.9% of the taxpayer’s wages, tips, and net earnings, without limit). Self-employment taxes amount to 15.3% of the first $132,900 of net earnings and 2.9% of any additional net earnings. This is in addition to any federal, state, and local income taxes and franchise taxes.
By contrast, owners of an S Corporation, can be employed by the S Corporation if providing services to the company, for its benefit, or on its behalf. The Company may pay a reasonable salary in exchange. When an S Corporation owner is employed
by their company, the company pays the employer portion of the Social Security and Medicare taxes (often referred to as “FICA” taxes) and the owner pays the employee portion as a withholding from their “reasonable salary”. Any income of the
company in excess of the salary still passes through to the owner, but none of that excess income is subject to self-employment tax.
To illustrate this scenario, let’s say you start a small company. After a few years the company is making $1,000,000 in net earnings and you pay yourself a reasonable salary of $100,000 per year. The S Corporation would pay you $100,000 and would also pay its share of the FICA taxes totaling 7.65% of the salary it paid you — in this case, $7,650. As the recipient of the salary, you would pay the employee’s portion of these taxes through normal payroll deductions also equaling 7.65% (or $7,650). The total amount of Social Security and Medicare taxes paid in this scenario is 15.3% of the $100,000 salary, or $15,300, of which $7,650 was paid by the company on top of the $100,000 salary. That leaves the company with $892,350 of net earnings that pass through to the owner without payment of any additional self-employment taxes.
In contrast, a single owner LLC cannot pay its owner a salary. If it were to receive $1,000,000 in net earnings in a year, its owner would need to pay social security taxes equal to 12.4% of the first $132,900 of income (the maximum amount of
income subject to social security taxes) and a 2.9% tax for Medicare on the entire $1,000,000, resulting in Social Security and Medicare taxes totaling $45,479.60, more than three times as much as the owner of an S Corporation in a similar
situation.
Although the tax savings can be sizable, there are limitations on who can form an S Corporation (or own an LLC electing to be taxed as one). An S Corporation may have no more than 100 shareholders and cannot be owned by another corporation, a
partnership, or non-resident alien. These limitations can be impediments to obtaining investors or selling your company.
Another issue is defining what is a “reasonable salary”. If an S Corporation makes $1,000,000 and pays its owner $10 a year, that’s clearly an unreasonable salary and could be considered tax evasion, a crime punishable by up to $100,000 in fines and 5 years in prison.
However, in the example where the owner of an owner takes a $100,000 salary on $1,000,000 in income, the salary is probably not reasonable, but it could be, depending on the nature of the services the owner provides. There simply is no cut and dry answer or formula.
Another issue with S Corporations is complexity. If you own a disregarded single-member LLC, the profits and losses are reported on your personal Form 1040 every year. If you have an S Corporation (or an LLC taxed as one), the company will
typically need to file a Form 1120S (U.S. Income Tax Return for an S Corporation), a Form 1120S Schedule K-1 (Shareholder’s Share of Income, Deductions, Credits, etc.), Form 940 (Employer’s Annual Federal Unemployment Tax Return), Form 941
(Employer’s Quarterly Federal Tax Return), and you as an owner/shareholder will typically need to file a Form 1040ES quarterly for your estimated payments in addition to your Form 1040 every year . . . and that’s just for federal taxes.
An S Corporation (or an LLC taxed as one) might be a good idea if your company can afford to pay its owners a regular, reasonable salary and still have enough earnings left over to result in a big self-employment tax savings.
If you are uncertain which business entity is right for you, consult with a knowledgeable business attorney and your CPA to evaluate what is best for your particular situation.
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
Leave a Reply