Whether you’re an SEO consultant or event planner, you’ve probably considered incorporating your business at one time or another. The decision to incorporate brings several businesses, from asset protection and lower liability to easier access to business credit and capital.
However, if you’re like most business owners, your biggest concern boils down to a single word…taxes.
Choosing the right business structure is a weighty issue, one you’ll want to consider carefully from all angles. The S Corporation is a popular way for small businesses to optimize their tax treatment. And with the S Corp election deadline approaching (March 15 for existing corporations), it’s a good time to examine this business entity.
What is the S Corporation?
The S Corporation actually begins as a general, for-profit C Corporation. After the corporation has been formed, it may elect ‘S Corporation Status’ by filing Form 2553 with the IRS in a timely manner (more on the deadline below…). With this S Corporation election, the company is now taxed as a sole proprietor or partnership rather than as a separate entity like the C Corp. This means that corporate profits and losses are “passed-through” and reported on the personal income tax returns of the shareholders. That’s why the S Corp is known as a “pass-through entity.”
An S Corp is comprised of shareholders. Its members receive dividends allocated in accordance with the number of shares each holds. One of the greatest advantages of this business structure is that it allows profits to be distributed to owners in lieu of wages. This way, owners avoid paying separate federal taxes on company profits and personal wages.
S Corporation and Your Taxes
The best way to understand the S Corp’s impact on your taxes is to examine a few example cases. Of course, state and Federal tax rules vary, so it’s important to check with your accountant regarding your specific circumstances.
Example 1: avoiding double taxation
Jeanie owns a graphic design business, which earned $100,000 in 2010. To keep things simple, let’s assume the tax rates for individuals and corporations are 28 percent each. If her business was a regular C Corporation, the business would pay $28,000 in income taxes, and Jeanie would take home $72,000. Jeanie would then owe 28 percent personal income tax on this $72,000 dividend ($20,160). Overall, Jeanie is paying $48,160 in taxes for the year. This is what’s called “double taxation.”
Now let’s say Jeanie had elected S Corp pass-through treatment for her business. As an S Corp, her business pays no income tax. The full $100,000 is distributed to Jeanie and she pays $28,000 on her personal income statement. It’s pretty easy to see the benefit between $28,000 vs. $48,160 tax payments for the year.
Example 2: passing through losses
Although you are hoping for profits, there may be years when your business sustains some losses as well. Like profits, losses must also be reported to the IRS. In this example, Frank quit his job as a plumber and opened a yoga studio in 2010. Since he’s just starting out and had a lot of upfront costs, his yoga business ended up with a loss for the year.
This loss could be “passed through” to Frank’s personal income statement, which helped him offset his other sources of income (i.e. the income from his plumbing job and stock profits). This helped him greatly reduce his personal tax liability for the year, and Frank was able to invest some of his refund into his yoga business.
Example 3: allocation of income
Charlie and Heidi open a chicken broth factory, each owning 50 percent of the business. Charlie is the investor and Heidi does all the work. Soon, the business is more profitable than they had ever imagined. Because Heidi has been working so hard, while Charlie has been on vacation for the past 8 months, they agree that Heidi should keep 75 percent of the profits and Charlie should get 25 percent. In an S Corporation, this arrangement would be a big problem.
In an S Corporation, each owner/shareholder must share in the income in direct proportion to their ownership. Since Charlie and Heidi each own 50 percent, they will be allocated 50 percent of the corporation’s income (at least for the purpose of computing their personal income tax statements), regardless of any other agreements between the parties. An LLC (Limited Liability Company) would be better in this situation, as it is flexible when it comes to allocating income amongst the owners. Charlie and Heidi simply agree to the arrangement and they will be taxed accordingly.
How to Form an S Corporation
Here’s the deal: If you have an existing Corporation (C Corp) or LLC, March 15th is your deadline for filing IRS Form 2553 with the IRS and electing S Corporation status for this tax year and forward. In other words, if your corporation/LLC existed on Jan 1, 2011, you need to file form 2553 by March 15, 2011 in order to have your S Corp in effect for the 2011 tax year. However, if you form a corporation or LLC on June 1, 2011, then your S Corporation deadline is August 15 (75 days from June 1).
If you miss the deadline, you’ll most likely be taxed as a C Corporation for the current tax year, and then your S Corp election will be effective for the following tax year. The IRS may give you a pass if you can show that your failure to file on time was due to ‘reasonable cause.’ Of course, no one wants to be at the mercy of the IRS, so play it safe and get your form in on time.
Your decision to incorporate will ultimately depend on all the unique aspects of your business. But regardless of your business type, taking a serious look at your legal structure is essential and is one of the easiest ways to save on your income taxes for years to come.
More in: Legal Structure
I recently incorporated as an LLC. What are the taxation differences between an LLC and an S-corp? They sound very similar to me.
Great to see you write a column here…
After a friend of mine suggested it a few years ago, my consulting firm became an S-Corp.
So far, so good.
My only complaint is the amount of paperwork required by my state; Ohio.
Anyway, for me, it’s worked out well.
@Robert, Thx for the comment! I sent an email with some information for you. @Joel, Great to hear from you! 🙂 -Nellie
I formed an S corp when I started my business over a decade ago. Not only have I seen the tax benefits, but it allowed me to create a SEP and contribute 25% of my payroll to my retirement.
One thing that I would like to mention is that the officers (usually the owners) must pay themselves a reasonable salary. The IRS is cracking down on S Corporations where the officers take distributions, in lieu of salary, in order to avoid FICA and medicare taxes.
Can you tell me how self employment taxes work with an S Corp vs just being a sole proprietor? My daughter is considering changing from a Sole Prop to a Corp or S Corp for tax reasons but I am not clear if self employment taxes still need to be paid from her income or if she would draw a payceck and all monthly taxes paid tha way?
@Debra and @Doug – thank you both for your comments. 🙂 @Reah As you may be aware, I am not a tax consultant, accountant, or a CPA, however, generally speaking, once one forms a Corporation , the corporation becomes an entity on its own and the corporation will file taxes under the corporation. As such, if one is an officer of the corporation, they can be placed on payroll and taxes would be paid through payroll and the corporation would file taxes. Feel free to email if this is still not clear: firstname.lastname@example.org 🙂
Nellie and SmallBizTrends Readers,
Thanks for your full disclosure Nellie regarding your specialization in forming corporations and other protective entities for business owners. Your article is helpful to business owners considering entity formation. However, I would like to offer some clarification to your article. The IRS considers carefully the level of compensation paid to an S Corporation Shareholder who is employed by the business. They look for what is known as “reasonable compensation” for such shareholders. Essentially, the IRS wants to see that the shareholder is being paid market rate for their services to the S Corporation. It is not a simple matter of paying all S Corporation shareholders “X” dollars to meet the reasonable compensation test.
This matter should be discussed carefully with the S Corporation’s CPA firm and documented so that if asked to produce evidence of reasonable compensation by the IRS, the shareholder is prepared to do so.
I hope this is helpful!
All the best,
Holly A. Magister, CPA, CFP
My French tutor business is currently an LLC and my accountant mentioned I should think about switching to an S corp for tax reasons. It sounds like more work for them though. Thank you for explaining the difference between C and S corporation structures.
@Holly Thank you so much for taking the time to read my article and you are absolutely correct! As you may be aware, CorpNet is strictly a business formation filing service and we always recommend our clients to a reputable CPA firm, such as yourself for specific tax questions. I will def make sure to add your comment to my next write up as I think it’s great information. Once again, thank you so much for your input.
@Anne I would definitely take your accountants advice. The process is actually quite simple; basically we would convert your current LLC into an S-Corporation; I would need to know the state that your LLC is filed in and then I can give you more details. In fact, we can actually file the paperwork for you to convert your LLC into an S-Corp. Let me know if I can help further.
My best, Nellie
Nice blog! Thanks for sharing such a great information.
Sure thing! If you have any questions feel free to email me directly at info at corpnet dot com
Thanks for sharing the reasons behind to hire the tax consultant for your business and how they can help you to manage your taxes..