The choice of entity is one of the most important decisions a new business owner faces. Many new businesses are automatically set up as an S-Corporation as part of the overall formation process without any thought given to the potential risks or benefits of that selection, or for any other option also available.
The question of whether a company should elect S-Corporation status depends on several factors that will be explored in this article.
A new business faces two decisions when being created – a legal entity decision and tax treatment decision.
Until the mid-1970s, there were three main types of legal entities available to a business – sole proprietorship, partnership, and corporation.
A sole proprietorship is a business owned and operated by a single person. That person reaps all the rewards of the business but also personally assumes all the debts and liabilities of the business. If the business is sued, the sole proprietor is fully responsible (subject to any insurance in place). If the business defaults on a loan, the sole proprietor is fully responsible and may lose any assets securing the debt, such as their personal residence, in the process.
A partnership is similar to a sole proprietorship except two or more people are the owners rather than a single person. There should be, but often times there isn’t, a written partnership agreement that spells out the duties and responsibilities of each partner and how they will share the profit and loss of the business. The debts and liabilities affect all partners in the same way as a sole proprietor except that their respective shares will most likely depend on what the partnership agreement states. In the absence of such an agreement, many disagreements can obviously arise.
Corporation (C Corporation)
One of the primary benefits of a C-Corporation is the limited liability protection it provides its owners that is not available to a sole proprietor or to partners. A C-Corporation is formed in the state in which it resides and is an entity in and of itself, owned by shareholders who contribute capital in return for a share of profits (and losses) and in the hope of distribution of profits (dividends) in proportion to their ownership percentage. The ease of raising of capital in this manner is another advantage a C-Corporation has over a sole proprietorship or partnership.
The shareholders can be, but often aren’t, involved in the day to day management of the company. The debts and liabilities of the C-Corporation are spread over the shareholders in proportion to their ownership percentage as well. For example, if a C-Corporation has 10,000 shareholders each with one share of stock and it defaults on a $10,000 loan, technically each shareholder is responsible for $1.00 of the debt. The disadvantages of a C-Corporation are that they are difficult to set up, the amount of paperwork involved in doing so, and the potential for double taxation on dividends paid to shareholders.
- Each state has its own rules regarding how a C-Corporation is formed and the business is required to prepare and file Articles of Incorporation according to those rules.
- The C-Corporation is required to hold annual meetings and record the minutes of those meetings; provide lists of officers and/or directors and maintain records of each shareholder and the number of shares they own. Failure to do so jeopardizes the veil of limited liability that this entity is set up to provide.
- The C-Corporation is a separate tax entity and prepares and files its own tax return and pays the resulting taxes. After taxes are paid, if there is a surplus the management of the C-Corporation may decide to distribute that surplus in the form of a dividend to the shareholders. This dividend is taxable to the shareholder on their own tax return. Hence the term “double taxation” – the dividends are paid after the C-Corporation pays its taxes and the shareholder is taxed on the after-tax dividend.
Over the last fifty years, states began to find ways to combine the benefits of all three of these types into an easy-to-create entity that provides a level of limited liability protection to all.
Limited Liability Company (LLC)
An LLC is organized under the laws of the state in which it resides. It can have any number of owners, typically referred to as Members. The main purpose is to simplify the rules and minimize the paperwork associated with a C-Corporation while extending the limited liability protection to smaller businesses that don’t have a large number of owners to spread the debts and liabilities over. However, while the other three entities mentioned above all have their own tax rules, the LLC is not a taxable entity
But what about an S-Corporation?
The simple answer is that up to now we have been discussing the legal entity a business chooses, and an S-Corporation is not a legal entity. The legal entity must be created before considering how it will be taxed and S-Corporation status is merely one tax treatment business can choose among several options.
As mentioned above, the sole proprietorship, partnership and C-corporation are all subject to certain tax rules.
- Sole Proprietorship. A sole proprietor files a business tax return as part of their individual Form 1040 along with any other income they may have – wages, interest, sales of stock and so on. The business return is commonly referred to as a Schedule C. The main tax consideration for the sole proprietor is the requirement to pay self-employment taxes on the income of the business in addition to regular income tax. Here is an example:
Gross Revenue: $100,000
Net income from the business: $50,000
The sole proprietor would add the $50,000 in net income to the other income they might have and pay income taxes on that amount. In addition, the sole proprietor must pay self-employment tax of approximately 15% over and above the normal income tax.
- Self-employment tax is how a sole proprietor pays their Social Security and Medicare because they don’t take a salary and get a paycheck with those taxes withheld like an employee (a sole proprietor takes a draw and is not considered an employee). But they are still required to pay those taxes, and this is done on their personal tax return
- Partnership. A partnership does not pay income taxes but it is required to file a separate tax return (Form 1065) so that the net income of the business can be calculated and then reported to each partner according to their percentage ownership (this is done on a Form K-1 for each partner). Once the partner’s income is determined they report it on their individual tax return and the tax treatment is then generally the same as for a sole proprietor. Each partner, therefore, is responsible for both income tax and the self-employment tax.
- Corporation (C-Corporation). A C-Corporation is a taxable entity. It prepares its own tax return (Form 1120) and pays its own taxes. It is not subject to self-employment taxes on its income (although it is required to match the Medicare and Social Security paid by and withheld from its employee’s salaries and wages). The individual shareholders do not report their share of the income of the C-Corporation on their personal tax returns, but they do have to pay taxes if they receive a dividend from the C-Corporation or if they sell their shares of stock at a gain.
- Limited Liability Company (LLC). As previously stated, an LLC is not a taxable entity. There is no specific tax return and it does not pay any tax on its net income. Rather, the IRS specifically states how it will be taxed or allows it to elect an alternative tax treatment if it qualifies.
- If there is more than one member in the LLC, the IRS specifies that it will be taxed as a partnership unless it elects a different treatment.
- If there is only one member (single-member LLC), the LLC can’t be taxed as a partnership and so the IRS calls this a “disregarded entity” –a fancy term for a sole proprietor and that is how the LLC is taxed unless it elects a different treatment.
- Regardless of the number of members, the LLC could elect to be taxed as a C-Corporation. This is rarely done, especially by small companies for the reasons mentioned above.
- Subchapter S-Corporation (S-Corporation). An S-Corporation is not a legal entity. It is an election that any of the four legal entities so far discussed can make to determine how they will be taxed. This is what is referred to above as “unless it elects a different treatment”.
What is an S-Corporation?
An S-Corporation is a tax election that the IRS allows to any business that qualifies and which makes the election to be treated as such.
In order to qualify for S-Corporation status, the following general conditions must be met:
- The entity must be a C-Corporation, an LLC or a partnership;
- This would include a single-member LLC but not a sole proprietorship unless the owner incorporates or becomes an LLC;
- Other partnerships and corporations are excluded from being shareholders;
- No foreign ownership;
- There can only be one class of stock authorized and issued;
- There can be no more than 100 Shareholders;
- All shareholders/members must consent to be taxed as an S-Corporation.
- The election must be made by the 15th day of the third month of the entity’s tax year – normally March 15;
- There is provision for a late election, but only with good cause and upon a petition to the IRS;
- Once the election is made, it stays in force until terminated;
- Termination would occur when any of the events that allowed the entity to initially make the election no longer exist, such as more than 100 shareholders or any number of shareholders no longer consenting to the election;
- If terminated, there is provision for reinstatement but normally not for five years.
How is an S-Corporation Taxed?
An S-Corporation is required to file its own tax return every year – Form 1120S. However, the S-Corporation pays no income tax, rather, the income or loss is passed through to each shareholder/member via a Schedule K-1 in proportion to their percentage ownership. In the case of a single-member LLC, all the profit and loss would go to the sole member. The income is then taxed on each individual’s tax return.
What are the Benefits of Being an S-Corporation?
There are two primary benefits to electing S-Corporation status. The first one is more beneficial to an S-Corporation with one or just a few members, all of whom are actively involved in the day to day management of the business. The second one benefits all shareholder/members.
Potential reduction in self-employment taxes. Referring to how a sole proprietor or a partner is taxed above, remember that the owner is subject to both income tax and self-employment tax on the net income of the business. However, Income from an S-Corporation is subject to income tax but not self-employment tax. This can be a significant benefit to the individual, especially if they are a sole member.
From the example above: Gross Revenue: $100,000 Expenses: ($50,000) Net income from the business: $50,000
The sole member of an S-Corporation would add the $50,000 in net income to the other income they might have and pay income taxes on that amount. But the sole member does not pay self-employment tax of approximately 15% over and above the normal income tax.If this sounds too good to be true, it is. The IRS is aware of this situation and has determined that the owner must take a reasonable salary in order to capture some self-employment taxes.
Revising the example: Gross Revenue: $100,000 Salary: ($20,000) Expenses: ($50,000) Net income from the business: $30,000
The sole member of an S-Corporation would add the $30,000 in net income from the S-Corporation and $20,000 from the salary reported to them on a W-2 (so that Medicare and Social Security have been deducted and matched by the S-Corporation), a total still of $50,000, to the other income they might have and pay income taxes on that amount. The result is that the sole member only pays self-employment tax through withholding and matching on $20,000. The $30,000 of income from the S-Corporation is not subject to the self-employment tax – roughly a $4,500 savings in this example.
Determining a reasonable salary is the biggest challenge in implementing this strategy. There are no specified rules, but a salary should be established to minimize potential scrutiny. If the taxpayer is audited, the reasonableness of the salary will be evaluated and potentially adjusted depending upon the taxing authority involved. A good rule of thumb is to see what other people in your industry doing the same type of work are earning. If that isn’t readily apparent, then good common sense is the general rule.
Again, this strategy is most appropriate for S-Corporations with one or just a few shareholders/members as too many would dilute the income and thus the benefit.
Deduction for 20% of income from a pass-through entity. In general, the new tax law passed in 2018 made provision for owners/shareholders/members of a pass-through entity to take a deduction on their individual tax returns equaling 20% of the individual’s share of the business income. There are many complicated rules and calculations associated with this deduction, but most smaller pass-through entities will enjoy the benefits. It should be noted that the S-Corporation election doesn’t benefit the owner if their business is already a sole-proprietor or they are in a partnership or LLC because they are already considered pass-through entities. Only a C-Corporation, which is not a pass-through entity, would benefit if its shareholders decided to elect S-Corporation status and that would have to be balanced against the relatively low C-Corporation tax rates.
What are the Disadvantages of an S-Corporation?
- Diminishing Returns on self-employment tax savings. The tax savings associated with an S-Corporation’s income not being subject to self-employment tax tend to diminish as the income increases. If S-Corporation income exceeds the Social Security earnings cap ($132,900 in 2019), then only the Medicare tax is saved at a rate of 2.9% each year. While still a benefit, it is quite a bit less than if Social Security is included.
- Social Security Credits. By paying less in Social Security taxes in the example above, you may not have built up as many Social Security credits as you are entitled to and, as a result, your benefits might be lower when you retire.
- Complicated rules. The laws pertaining to S-Corporations get increasingly complex the larger and more sophisticated a business gets, especially if the number of shareholders/members nears 100 or if the business wants to attract foreign ownership. Likewise, a C-Corporation that has been in business for any length of time which decides to make the S-Corporation election faces a unique set of challenges. However, for most business owners reading this, these drawbacks would not apply and are beyond the scope of this discussion.
- Basis. One factor that a business owner considering S-Corporation status must consider is their basis. Basis is a complicated concept, but a basic understanding is necessary because, if it is ignored, it can lead to costly tax issues. It is calculated separately for each shareholder/member. Essentially, basis is the following money or capital invested by a shareholder/member at inception
plus money or capital invested by a shareholder/member while the business is operating plus The shareholder/member’s share of profit of the business year to yearlessMoney taken out of the business by the shareholder/member as a distribution less the shareholder/member’s share of loss of the business year to year. While this is a generic example (there are other factors affecting basis beyond the scope of this discussion) the key point is that if it results in a negative number (negative basis) then certain rules are applied.
- First, while losses of an S-Corporation can be deducted by the shareholder/member on their individual tax returns just as income is reported there, the losses can’t be deducted if they result in a negative basis. The losses must be carried forward to the following years until the taxpayer has a positive basis.
- Second, if the shareholder/member takes distributions while having or that cause negative basis, the IRS considers that a dividend, not a distribution, which is subject to tax.
- Affect on retirement plan contributions. In general, businesses can set up retirement plans, of which there are several types. While the use and tax treatment of these plans could warrant their own discussion, certain of these plans base contributions to them on earned income and compensation. S-corporation income is not considered earned income or compensation so the amount that can be contributed might be significantly less than in other types of entities.
As stated previously, many business owners set up, or are advised to by others, an S-Corporation as a matter of course. Hopefully, this discussion has made it clear that there are many factors that go into this decision.
The savvy business owner will generally take the following approach:
- Determine the appropriate legal structure that best suits their business. In reality, the LLC probably makes sense for most small businesses. But remember, an LLC is a legal entity that is free to choose the tax treatment that best suits its needs.
- Determine, based on the legal entity formed, how the business wants to be taxed. This very well may be an S-Corporation, but it pays to take a little time up front to make sure given the advantages and disadvantages mentioned above.
The business owner should consult a professional to help in these matters. While our CPA firm doesn’t set up legal entities, although we can direct you to competent people who do, we can help you with the planning portion to make sure you understand all the factors necessary in setting up the entity. We offer a free consultation to discuss this and any other matters you may need help on in setting up your business. If, after that, you think an S-Corporation is the right way to proceed, we can fill out and file the paperwork necessary to make the election as well as monitor your books to make sure that you take full advantage of the tax benefits of an S-Corporation while avoiding the costly tax problems that could arise if not watched closely.