Q: Tax Playa, what are the advantages and disadvantages of S-corporations? Everyone who has a successful business seems to be opening one.
Morgan, Washington DC
A: S-corporations, unlike regular (or "C" corporations) do not pay income tax themselves. Rather, they pass through any profit or loss to the S-corporation shareholders ratably. This has the advantage of avoiding double taxation and most payroll taxes. It has the disadvantage of taxing all business income at the highest personal marginal tax rate of the shareholders.
A corporation or LLC may elect to be taxed as an S-corporation by filing Form 2553, Election by a Small Business Corporation.
In order to elect, the corporation or LLC must:
- Be a corporation or LLC that makes a timely filing of the 2553 (by March 16th for calendar-year taxpayers)
- Have no more than 100 shareholders (corporation) or members (LLC)
- The only shareholders/members are individuals, estates, tax-exempt entities, or trusts
- It has no non-resident alien shareholders/members
- It has only one class of stock
- It is not an ineligible corporation like a life insurance company or credit union
- It uses a calendar year
- Each shareholder/member consents
Once elected, the S-corporation is a separate tax entity. It keeps its own set of revenues, expenditures, and capital assets separate from any shareholders. However, it does not pay taxes itself.
Rather, it files an annual return (Form 1120-S) every March 15th, and "passes through" any reported profit or loss to its shareholders/members' Form 1040, Schedule E ratable to the degree of ownership of the S-corporation. So, if four people own an S-corporation, but one has a 40% ownership, the profit will be split 40-20-20-20.
The S-corporation does not actually need to cut a check each year for the profit share. This is simply how the taxes are paid. Many S-corporation owners do not understand this. This is one disadvantage to an S-corporation--the tax must be paid in the year of profit by the owner, no matter what. There is virtually no wiggle room to play around with tax years.
Each owner has a basis in the S-corporation equal to his cash contributed and profits retained minus cash disbursed and losses realized (among other complications).
When the money is passed through to shareholders, they pay ordinary income tax on their profits at whatever marginal income tax rate they find themselves in. This is both an advantage and a disadvantage. The advantage is that there is no potential for double-taxation (corporate income tax and personal income tax). The disadvantage is that every dollar of profit is taxed at the highest marginal income tax rate of the owner, which may be as high as 35%.
A key advantage to S-corporations, and the main reason they are the most popular corporate form, is that any profits passed through are not subject to self-employment tax. This is in sharp contrast to sole proprietors, who must pay the onerous self-employment tax on every dollar of profit.
In order to prevent S-corporation owner/employees from avoiding payroll tax entirely, the IRS requires them to receive a "reasonable salary" from the company. "Reasonable" means what the services that are provided would garner in the open market, relative to all the facts and circumstances. Of course, like any other wage, FICA taxes must be paid. As a result, S-corporation shareholder-employees should pay themselves the smallest reasonable salary they can get away with.
Another disadvantage of S-corporations is that more than 2% shareholder-employees are not eligible to receive fringe benefits paid by the corporation. A specific exception to this is made for pension contributions. Another exemption is made for health care premiums and HSA contributions, but this can get a bit complicated. It involves paying a wage to the affected employee, not paying FICA on that wage, and having the employee take an above-the-line adjustment for the items on their 1040.
As a general rule, I only recommend S-corporations for entrepreneurs whose business has gotten consistently large enough that being a sole proprietor doesn't make sense anymore (I use $20,000 in profit or more as a rule of thumb here). Within that subset, I would only recommend it to people not organized or disciplined enough to not "ATM" their corporate account (which, in a C-corporation would be classified as a dividend).
If a company is big enough not to be a sole proprietorship anymore and disciplined enough to keep a good set of books, I recommend going with a C-corporation for the following reasons:
- Double taxation can be avoided with care and planning
- There is no requirement to pay a salary of any kind
- One benefits from the graduated corporate income tax structure
- One can choose a fiscal year different from the calendar year
- Fringe benefits are fully-allowed.
- There are no restrictions on the number/type of shareholders or the class of stock