S Corporations. What are they and should I have one?
This is quite possibly one of the most frequently asked questions we get from new business owners. S Corporations get a lot of hype, some rightfully so, but it is important to know that an S Corporation isn’t right in every situation. Let’s break it down.
What is an S Corporation?
Believe it or not, an S Corporation isn’t actually a type of entity it’s merely a tax classification. When forming an entity you would form a Corporation, Partnership, LLC, or choose from a number of other entity types. Once the entity is formed, you would then make an election to be taxed as an S Corporation by filing Form 2553 with the IRS.
How are S Corporations taxed?
To fully understand, it is important to first understand how other entity types are taxed.
C Corporations
C Corporations are currently taxed at a flat 21% of net business income for federal tax purposes and 8.84% of net business income for California purposes. When owners of a C Corporation (shareholders) take distributions of income, those distributions are then taxable to the shareholder at their ordinary federal and state income tax rates. This is referred to as double taxation because the shareholder is being taxed on income that the corporation has already paid tax on.
Limited Liability Companies
LLCs are what is known as a flow through entity. This means that the net business income of the LLC is not taxed by the IRS but rather flows through to the owners (members or partners) income tax returns where it is taxed at the member’s ordinary income tax rate. In addition, general partners or those that are actively involved in the management of the entity also pay self-employment tax on that income. Self-employment tax is equivalent to employee and employer portions of payroll tax. The LLC itself pays a minimum tax of $800 to the state of California plus an LLC fee based on the following schedule of gross revenues:
$250,000 - $499,999 / $900
$500,000 - $999,999 / $2,500
$1,000,000 - $4,999,999 / $6,000
$5,000,000 or more / $11,790
S Corporations
S Corporations are also a flow through entity. The S Corporation pays no federal income tax and pays California tax of 1.5% of net business income with a minimum of $800. The net business income of an S Corporation flows through to the owners (shareholders) income tax returns where it is taxed at the shareholders ordinary income tax rate. The income is not subject to self-employment tax but the shareholders who render services to the entity, often referred to as officers, must pay themselves wages which are subject to payroll taxes.
So why would I choose to be taxed as an S Corporation?
One of the most common reasons for choosing to be taxed as an S Corporation is to avoid double taxation by remaining a C Corporation. But there are many other situations where choosing to be taxed as an S Corporation could be beneficial.
We’ll use two examples to demonstrate why an S Corporation could be advantageous.
Example 1:
MarbleMakers is a specialty marble warehouse selling marble slabs to customers for residential and commercial home building. They sell over $5,000,000 worth of marble slabs each year but their costs are high from the cost of the marble itself, to the cutting and processing to make it smooth, to the rent on the warehouse space to store it. The company’s net business income is approximately $200,000 each year. As an LLC, the company would pay $800 tax plus $11,790 LLC fee for a total of $12,590 in CA taxes/fees. As an S Corporation, the entity would pay CA tax of $3,000. That’s an entity level tax savings of $9,590 just by being taxed as an S Corporation vs. an LLC.
Example 2:
Abby is an interior designer and the sole owner of her business. Her annual net business income is approximately $200,000. As an LLC, Abby would pay ordinary income tax plus self-employment tax on her $200,000 of earnings. As an S Corporation, Abby pays herself a reasonable salary of $100,000 on which she pays payroll taxes, and the remaining $100,000 of income is taxed at her ordinary income tax rates. By being taxed as an S Corporation, Abby avoids paying self-employment taxes on $100,000 of income.
Are there disadvantages to being taxed as an S Corporation?
Yes.
Being taxed as an S Corporation means operating as an S Corporation which in most cases requires bookkeeping services, payroll processing services, increased tax prep fees, etc. In some cases, the additional costs and compliance required to be taxed as an S Corporation outweighs the tax savings.
S Corporations have restrictions on the number and type of permissible shareholders.
S Corporations are much less flexible regarding how owners can be paid. For instance, distributions from an S corporation must be in proportion to each owner’s interest.
S Corporation owners wages are not eligible for the Qualified Business Income deduction meaning that an S Corporation owner in some cases will get a smaller QBI deduction than if their business was a different entity type, like an LLC.
The bottom line.
While there are many advantages to being taxed as an S Corporation, it’s not the right fit for every situation. It’s especially important with ever changing tax laws to talk to a tax professional to determine if an S Corporation is the right fit for you.