TAX

S Corp Taxes

Electing to be taxed as an S corp can be a great choice for many entrepreneurs. S corps provide their owners (shareholders) with the best features of LLCs and C corps. Like LLCs, S corp shareholders are taxed on business income at the personal level. Like C corps, S corp shareholders can be considered employees, not subject to self employment tax. In combination, these features mean that pass through business income is exempt from self employment tax. Further, since income is pass through, amounts distributed to an S corp shareholder in excess of salary payments can be tax free, whereas in a C corp such payments would be taxed as dividends. Overall, compared to the other organizational structures S corps are extremely versatile and can be a great entity choice for entrepreneurs.

SPEAKER

Radka, an expert in astronomy, is a professional speaker based in Malibu, California who currently does business as a sole proprietor. After hearing about S corps, Radka was convinced she wanted to change her organizational structure. To be taxed at the federal level as an S corp, Radka could incorporate in her state as a C corp or LLC and then make the S election by filing Form 2533 before March 15th of the first year she wants to be taxed as an S corp. Since Radka would be a 100% shareholder in her new business, likely, all she would need to do to meet the S corporation requirements is ensure she only has class of stock in her new business.

DEVELOPER / ENGINEER

Misha has a web development business organized a C corp that has always elected to be taxed as an S corp. Recently, Misha was approached by a partnership that wanted to invest in his business. After accepting the investment, he found out that he would no longer be able to make the S election since he now had a partnership shareholder in his business. When Misha prepares his taxes, it will be his responsibility to acknowledge this event and file accordingly.

PROFESSIONAL SERVICES

Ambereen is a structural engineer organized as a single member LLC. She has always made the S election. Last year her business made $120,000. She deemed a reasonable salary would be $90,000 per year and accordingly, paid herself $7,500 ($90,000 /12) each month. She withheld federal income tax, social security and medicare from her wages and paid employer payroll taxes on the $90,000. The $30,000 of income remaining in her business was passed through to her, and she paid personal income tax on it. Because Ambereen elected to be taxed as an S corp instead of a single member LLC, she did not have to pay self employment tax on the $30,000 of undistributed income.

UBER DRIVER / RIDESHARE

Ethel is a full time Lyft driver organized as a single member LLC. She has always made the S election. Last year her business made $65,000. She deemed a reasonable salary would be $12,000 per year and accordingly paid herself $1,000 each month. She withheld federal income tax, Social Security and Medicare from her wages and paid employer payroll taxes. She then took the remaining $53,000 out of her business as distributions, which are not subject to Social Security, Medicare and unemployment taxes. Shortly after filing her Form 1120S, the IRS informed Ethel that it did not consider $12,000 per year a reasonable salary and that Ethel would have to reclassify and pay tax on some of her distributions.

DESIGNER

Grace is a freelance graphic designer who operates a corporation that is taxed as an S corp. When business was booming, Grace was too busy to do her accounting so she began comingling her business and personal assets, her business also took out an unsecured $35,000 loan to purchase some printing equipment. Last year Grace struggled to bring in new work and defaulted on her loan. Even though Grace's corporation would ordinarily limit her personal liability to her lender, since she had commingled her business and personal assets a judge decided to pierce the corporate veil and as a result, Grace had to liquidate her personal assets to pay back the money she owed on the equipment.

S CORP TAX TIPS

To elect to be taxed as an S corp you must be an eligible domestic corporation (refer to IRS for details) with only one class of stock and not more than 100 shareholders. Further, your shareholders cannot be partnerships, corporations or non-resident aliens. As an S Corp owner, your share of business income is taxed at personal income rates. This is because S Corporations are so-called "pass-through" entities, which are businesses without a separate tax rate. Business income "flows" or "passes" through to the personal level before being taxed. S Corp owners, like other pass-through entities, are responsible for both income and self-employment tax (the employee and employer portion of Social Security and Medicare contributions). The 2017 Tax Cuts and Jobs Act established a new tax deduction available to taxpayers with business income, referred to as the "business income deduction". This deduction effectively lowers the tax rate for millions of small businesses and self-employed taxpayers. The deduction is up to 20% of business income after deductible expenses, but can be limited or disallowed by various factors like total taxable income and type of business.
Income from your S corp can be taxed a couple different ways. First, shareholders who work for their S corp must receive a "reasonable salary" (deductible), which will be taxed the same as wages from a normal 9-to-5 job. Second, any remaining earnings from your S corp (after you have been paid a reasonable salary) will be pass through (similar to LLCs), and subject to taxes at your individual income tax rate. The major benefit here compared to an LLC is that LLC owners pay Social Security and Medicare taxes on all of their income, while S corp shareholders instead only pay these taxes (and unemployment tax) on their reasonable salary. In other words, the pass-through income from S corps is not subject to self-employment taxes.
As an S corp shareholder you get to determine how much of your compensation should be considered salary, subject to FICA and unemployment taxes, vs. distributions, which are not subject to these taxes. Remember though, if too much of your compensation is comprised of distributions it could be considered an audit red flag and the IRS may force you to reclassify some of your distributions as part of your salary and / or pay additional taxes.
Both LLC's and C corps can make the S election by completing Form 2553. Note that your election must be submitted to the IRS by March, 15th of the year you first want to be taxed as an S corp. Further, keep in mind that taxation of S corps varies by state, so while you may be able to take advantage of favorable federal treatment, you may have to adhere to different tax rules when preparing your state taxes.
S corps typically enjoy the limited liability benefits of corporations and LLCs, meaning that your personal liability for corporate obligations is limited, even as a sole owner. Typically, only your investment will be at risk unless you fail to put enough money into your business, you commingle personal and business assets, you engage in fraudulent behavior or fail to follow corporate formalities.
If you organize as a corporation and make the S election, you may be subject to some additional administrative requirements, compared to LLCs and sole proprietorships.You may need to draft bylaws, appoint directors, hold board meetings, document actions taken during board meetings and file separate tax returns, to name a few.

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