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How Do S Corps Work and Should You Form One?

How Do S Corps Work And Should You Form One? by Galia Schmidt

Many small business owners wonder exactly what an S Corp is, and if it’d be advantageous to their business to form one. Here are 6 points to help you have a better idea of what an S Corporation is, and whether or not you should form one (with the help of your business attorney and accountant, of course).

  • 1. S Corp is a tax status, not an entity type.

Contrary to popular belief, there is no legal entity called an S Corp. S Corp is a tax status, not an entity type. That means when you form a new company, the company you’re forming will most commonly be an LLC or a C Corporation. After the business entity is formed, you elect to be taxed as an S Corp with the IRS. 

If someone says their business is an S Corp, that description is technically incorrect. The more accurate way to think about it is that you have, for example, an “LLC with an S Corp tax election.” You aren’t “forming” an S Corp, you’re forming an LLC or a corporation and then choosing to be taxed as an S Corp.

  • 2. C Corp and LLC default taxation.

First, some definitions to keep things clear:

  • -Income tax: the tax an individual or business is required to pay by the government based on income made; amount is based on income levels and available deductions.
  • -Self-employment tax: Business owners who are not employees of their business (more on this below) are required to pay self-employment taxes in addition to income taxes. This self-employment tax covers contributions to social security and medicare. It is generally more than income tax but less than employment taxes. The federal self-employment tax rate is currently 15.3%.
  • -Employment tax: The taxes a business’ employees are required to pay to the government when a person is an employee of the business. These tax contributions cover federal income tax withholdings, social security, Medicare, and Federal Unemployment taxes, as well as state requirements such as California’s unemployment insurance and state disability insurance, among others. Employment taxes tend to be expensive for the business owner.

If a corporation does not elect to be taxed as an S Corp, this is how taxes work:

The corporation is considered its own legal entity. This means that all income the corporation makes is income that the corporation has to pay taxes on, and the corporation files its own tax return. Then, as an owner, you’ll pay yourself a salary, and then that income is taxed again as your personal income on your personal tax return. That means the same money is being taxed twice! This is what the phrase “double taxation” refers to.

Because of this double taxation, corporations often end up being more expensive for a small business owner because the same money is being taxed twice.

If an LLC does not elect to be taxed as an S Corp, this is how taxes work:

Unlike a corporation, an LLC is not considered a separate entity from its owner. It does not file its own tax return, and does not pay its own income taxes. Instead, the income and expenses of the LLC flow through the owner’s personal tax return, and the owner pays all owed taxes based on their personal tax bracket. This type of taxation is called “pass through” taxation. The owner is required to pay self-employment taxes on all LLC income. Any money the LLC makes belongs to the owner and will be taxed as self-employment income, regardless of whether the money stays in the business bank account or the owner pays themselves with it as personal income. In this typical scenario, the owner is not an employee of the LLC; any money the owner pays themselves out of the LLC will be a draw, and the owner will pay self-employment taxes but not employment taxes. Because the LLC owner isn’t paying employment taxes, and because the LLC income isn’t double-taxed like a C Corporation, this structure tends to be cheaper for a small business owner than C Corp taxation.

  • 3. S Corp taxation.

When a company elects to be taxed as an S Corp, the owner becomes an employee of the business, and will get a paycheck just like any regular employee. The amount you pay yourself must be a “reasonable salary.” Reasonable salary is not clearly defined by the IRS, but generally, the business owner should pay themselves in the ballpark of what they could pay someone else to replace them in their role as a technician in the business. Employment taxes will come out of these paychecks. Generally, the taxes paid on this salary will be more than the owner might otherwise pay in self-employment taxes, because there are additional taxes taken out for employees. However, the owner can also take money out as an ownership draw (aka distribution, dividend, or profit), in addition to the money paid as salary. Owners are not required to pay self employment taxes on this draw, just regular income tax.

To say this in a different way, if a business is taxed as an S Corp, the owner gets paid in two ways. First, as an employee, with a reasonable salary, with accompanying employment taxes. Second, via ownership distribution, where no self-employment or employment taxes are required.

S Corps do not file their own return like a regular corporation. However, they do file an “informational return.” An accountant can help you file your S Corp taxes.

  • 4. Why elect S Corp taxation if you’re a corporation?

Corporations tend to be expensive, especially for small businesses, because of the double taxation problem. If a small business is a corporation, it is often a good idea to elect to be taxed as an S Corp to avoid double taxation and cut down on taxes. This is very common for California professional businesses that are required to be corporations and cannot be LLCs, such as law firms, medical practices, and architecture firms. S Corp election tends to be cheaper in these industries.

LLCs don’t have double taxation, so why would anyone want to elect to be taxed as an S Corp? Depending on how much revenue your business is making, it might be cheaper to elect S Corp taxation. If the business is still small and growing, regular LLC taxation may be cheaper– you are not required to pay employment taxes, and you’ll be taxed at whatever normal tax bracket you’re qualified for. However, once the LLC starts bringing in more money, it may be cheaper to pay yourself a reasonable salary (despite the required employment taxes) because the rest of your profit distributions will not be subject to self-employment or employment taxes. This analysis should be done by an experienced accountant who can help you run your numbers and advise you on which scenario would get you the best tax savings.

  • 5. S Corp requirements.

Being taxed as an S Corp can be a pretty good deal, so the IRS has imposed additional restrictions on these businesses.

  1. The entity must be domestic. This means the business must be headquartered in the United States, and cannot be a foreign-based business doing business in the US.
  2. Owners can be individuals, certain trusts, and estates. Owners cannot be partnerships or corporations.
  3. Owners must be US citizens or be legally recognized resident aliens.
  4. Shareholder restrictions may also apply to non-owner spouses of the owners! This is because California is a community property state, so a non-owner spouse may still have a legal interest in the business, and the IRS still wants these rules to apply. Talk to your business lawyer if you think this may be an issue in your business. 
  5. The business cannot have more than 100 owners.
  6. The business can only have one class of stock. Generally, this means that you can have different voting rights between owners, but you cannot have different rights relating to pay. (For example, you cannot have one owner get priority payments over another owner). This is another issue to discuss with your business attorney if you want your owners to have different voting and/or economic rights.
  7. Certain types of business are never allowed to be taxed as an S Corp, such as certain financial institutions, insurance companies, or domestic international sales corporations.

Please check with your business attorney to make sure your business qualifies for S Corp taxation. You don’t want to apply, assume you’ll be taxed as an S Corp, and then get your tax status revoked!

  • 6. Changing your tax election.

You do not have to decide right when you form your new company whether to be taxed as an S Corp. You can elect S Corp taxation down the road, as your business becomes more profitable  and S Corp status becomes beneficial. Conversely, you can elect to remove S Corp taxation if it no longer seems to be a good fit.

Notably, there are restrictions on when you can apply for S Corp status, how many times you can elect it, and when you can remove the tax status. While S Corp tax status can be very beneficial to a business and its owners, it is not a decision to be made lightly. Consulting with an accountant and a business lawyer is your best bet for success.

Think your business needs S Corp tax status? Contact us! We can help.

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