S-Corporations: Everyone's Favorite Business Structure

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:

1. Be a corporation or LLC that makes a timely filing of the 2553 (by March 16th for calendar-year taxpayers)
2. Have no more than 100 shareholders (corporation) or members (LLC)
3. The only shareholders/members are individuals, estates, tax-exempt entities, or trusts
4. It has no non-resident alien shareholders/members
5. It has only one class of stock
6. It is not an ineligible corporation like a life insurance company or credit union
7. It uses a calendar year
8. 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:

1. Double taxation can be avoided with care and planning
2. There is no requirement to pay a salary of any kind
3. One benefits from the graduated corporate income tax structure
4. One can choose a fiscal year different from the calendar year
5. Fringe benefits are fully-allowed.
6. There are no restrictions on the number/type of shareholders or the class of stock

Comments

[David V from Houston, TX]

On reason #2 on being a C-Corp, you mentioned that there is no requirement to pay a salary of any kind. My CPA informed me that as a board member who participates in the business, I must be an employee of the corporation. What are your thoughts on that?

[Kevin]

I don't believe there's any such requirement that a board member be treated as an employee, for Federal income tax purposes. There may be some state law requirement. Ask him/her for the rationale for his assertion.

[Krish Kumaresh]

Tax Playa,

I am a software professional, incorporated (S-Corp) and with a sizeable revenue annually. My wife is just setting out as a real estate consultant.

Would it be prudent to switch over to a C-Corp?

Krish, VA

[Ryan Ellis]

Krish:

I would need to know a LOT more information than that to make a recommendation. Have you read my article on business entity formation choice? That might help.

Email me separately and we can set up a time to talk.

[Scott, FL]

Can a person who did not take salary but did have more than 10K flow through to personal tax return from their S Corp make an IRA contribution?

[Rob, MN]

Can I set up a 529 plan for my kids under my S-Corp?

...AND can I own a separate 529 plan?

[Nick]

TaxPlaya,
I recently established an S-corporation for my Enterprise Consulting Business and I am trying to figure out how to reduce the amount of taxes I end up paying. I have been reading quite a bit, however keep in mind I am new to all of this and I could be way off track.

Lets say my S-Corp brings in 500k in a year and I pay myself(the sole employee/owner) a salary of 150k. That means that as the sole owner, I receive the 350k profits at the end of the year. I do not need or want the 350k of profits and I especially do not want to pay taxes on all of that. I would rather use as much of that money on "necessary and ordinary" business expenses.
One area that I have been looking into is, real estate. I currently have a home office and am the only employee working there. Couldn't I say that I am planning to expand in years to come and need to purchase and additional piece of property/building/house through the business in order to sustain more employees in the future? In the mean time, while I am still a one man show, I can lease out any additional space and the property will hopefully increase in value.

So to recap... Instead of taking the profits as a check to me personally and paying taxes on it. I would rather re-invest the profits into the company(preferably as real estate) in hopes that in the long run, I will make more profit. Is this possible or am I living in a dream world?

Cheers,
Nick

[K. Barton]

My husband is a sole owner and employee of a small remodeling co. He files as an S-Corp. He must be a Corp. to get construction insurance coverage and to pull building permits.

He is currently being taxed to death! His Co. has to match all of his FDIC & SS payments and then he pays regular income tax. After all of this there is little to no profit remining. He made more money before being a Corp. by just paying regular income taxes. What should he do so that he can stay in business for himself?

[K. Barton]

Sorry in my letter I said FDIC but meant to say FICA taxes.