Paying taxes is unavoidable, yet that doesn’t mean you need to pay more than necessary. You can make smart decisions to minimize your tax burden, without running afoul of the IRS.
For small businesses and entrepreneurs, business structure impacts how you pay taxes, and potentially how much you pay as well. The biggest difference is whether the business is its own entity responsible for paying taxes or whether the business’ profits are passed along to the owners’ individual taxes.
How to Avoid Double Taxation
C Corporation vs. S Corporation
A C Corporation is taxed as its own entity. The corporation files IRS Form 1120 each year to report its income, deductions and credits. Profits are typically taxed at corporate income tax rates. That’s pretty cut and dry, but where small business owners can run into trouble is through something called double taxation. That’s because when the corporation distributes dividends to the stockholders, these dividends are taxed on the stockholders’ personal tax returns.
If you’re a small business owner and expect to put some of the end of the year profit into your own wallet, the money could end up being taxed twice: first, the corporate profits are taxed at the corporate level and then the distributions are taxed on an individual level.
To avoid double taxation, a corporation can file a special election, called S Corporation election, with the IRS. As an S Corporation, the company itself no longer pays taxes on the profits. Instead, any profit or loss is passed to the stockholders. The stockholders then report their share of the profit/loss on their personal tax returns. If you own 33 percent of an S Corporation, then you’ll need to report 33 percent of the company’s profit with your personal tax return.
From a high level, this “pass-through” taxation is the key difference between a C Corporation and an S Corporation. But there are a few other key details to understand about S Corporations:
- You’re also able to pass a loss onto your personal income taxes. If the business experiences a loss for the year, you’ll report your share of the loss on your return and this can offset any other income you might have.
- Stockholders are required to report their percentage of the profit/loss whether or not they actually receive that money as a distribution. So, let’s say you own 100 percent of an S Corporation and it makes X dollars in profit for the year. You decide to keep that money in the business in order to make some big purchases next year. You still are required to report the profit on your individual tax return. If you anticipate keeping a significant amount of money in the business, you may be better off as a C Corporation.
- S Corporation distributions aren’t subject to FICA/self-employment taxes. This is one tactic that self-employed entrepreneurs use to minimize their self-employment taxes. However, if you have an S Corporation and are actively working in the business, you’ll need to pay yourself a market-rate salary for the work you do. In other words, the IRS won’t let you pay yourself entirely in distributions to avoid self-employment tax.
- Lastly, we tend to talk about S Corporations in terms of C Corporation vs. S Corporation, so you may be surprised to learn that an LLC (Limited Liability Company) can also elect S Corporation treatment. An LLC already enjoys pass-through tax treatment, which begs the question, why would an LLC ever need to elect to be taxed like an S Corporation? The answer is related to the previous point: the S Corporation allows the owner to divide up the business’s earnings into both salary and distributions. By electing to have your LLC taxed like an S Corporation, you can have pass-through taxation, the minimal formality of an LLC, and be able to take out some profit as a distribution that’s not subject to FICA/self-employment tax.
Who Qualifies for S Corporation Status?
The IRS places strict requirements on S Corporation status, so not every business will be able to qualify. In order to qualify, the company must meet all the following criteria:
- It needs to be a domestic corporation
- Shareholders cannot be partnerships, corporations or non-resident aliens
- You can’t have more than 100 shareholders
- You can have only one class of stock
- You need to be an eligible corporation (some financial institutions, insurance companies and domestic international sales companies aren’t eligible).
How to Elect S Corporation Status
Electing to be an S Corporation is relatively simple: you’ll need to file IRS Form 2553. The only catch is the deadline. You need to file Form 2553 no more than two months and 15 days after the beginning of the tax year the election will take effect.
If you want to be treated like an S Corporation for Tax Year 2017 (assuming you follow a calendar tax schedule), you need to file Form 2553 by March 15, 2017. If it’s after March 15, S Corporation treatment will generally begin with calendar year 2018.
As the deadline approaches, think about your company’s business structure and determine if an S Corporation is right for you. A tax advisor or small business expert can help you decide if this is the right course of action for your specific situation.