Saving Business Taxes with an S Corporation: A Short Primer
S corporations, or Subchapter S corporations, produce several tax benefits as compared to sole proprietorships, partnerships, and C corporations.
The big benefit—and the one that people usually talk about—are the payroll tax savings. To understand how this works, let me compare two alternatives: A sole proprietor making $90,000 a year and an S Corporation making $90,000 a year.
Of course the taxes that a sole proprietor pays depends on his or her filing status, itemized deductions and family size, but typically such a person might pay about $12,000 in federal income taxes. The person might also pay another chunk in state income taxes.
In addition to these income taxes, the proprietor also pays a 15.3% self-employment tax on the $90,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social security and Medicare tax) equals $13,000.
Things work differently for the S corporation, however. To make calculations easy, assume the S corporation is owned by a single shareholder. In this case, the S corporation must break the $90,000 of profit into two buckets: wages and the leftover (which is called a distributive share). If the wages equal $40,000 and the leftover distributive share equals $50,000, the business pays Social Security and Medicare taxes (equivalent to self-employment tax) equal to roughly $6,000.
In this case, even though the two businesses make the exact same amount of money, the S corporation pays roughly $7,000 less in tax each year.
S Corporations also provide a couple of other benefits--benefits which are a little more difficult to quantify but still important nonetheless.
One such benefit is that S corporation losses (such as those that often occur in the early startup years) can be used as tax deductions on the shareholders personal income tax returns.
Another such benefit is that the S corporation isn't taxed on S corporation profits at least by the federal government.
A S Corporation seems too good to be true… is there a catch?
Well, yes and no. The catch with an S corporation is that the salary you set for a shareholder-employer such as the owner needs to be reasonable. A low salary might save payroll taxes temporarily, but the IRS should be able to successfully challenge such a salary. The 1120S tax return, which is what an S corporation files, makes it very easy to see when shareholder-employees are under-compensating themselves.
Can sole proprietors become s corporations?
People commonly search web sites like this one for comparative information about s corporations and the self-employed. So let me make just a couple of quick comments: First, a sole proprietor can become an s corporation. And, in fact, most of the do-it-yourself kits I sell here seem to be purchased by self-employed individuals converting their sole proprietorships to subchapter s corporations.
Another quick comment: If you're interested in comparing the features of sole proprietors and subchapter s corporations--in other words, if you're looking for s-corp vs. sole proprietor information--look at the articles available at this web site that discuss the advantages and disadvantages of s corporations. They provide comparisons of the s corporation and sole proprietor forms.
How do you set up an S Corporation?
By correctly filing a timely 2553 form with the IRS service center that will process the S corporation tax return. You typically want to either pay a professional to do this or carefully, carefully read the instructions that accompany the 2553. Note, too, that some states require state-level s elections to be made. If you want some help with the 2553 or with the state-level election, consider purchasing the do-it-yourself kit for your state.
A word about timing of the S election. An S election generally needs to be made by March 15 in order to be effective for that year. For example, in general, for your business to be taxed as an S corporation for 2006, you need to make the S election by March 15, 2006.
Can any business set up as a S Corporation?
No, there are some restrictions. For example, insurance companies can’t become S corporations. Also, if a business is owned by another business, an S corporation often can't be set up. (As noted elsewhere on this web site, basically only individuals can own S corporations. So if a business is owned by a partnership or a regular non-S corporation (which is called a C corporation), the business can't set up as an S corporation. S corporation shareholders are also limited to 100 shareholders or less--although this rule is relaxed somewhat in the case of families.
Can professionals (doctors, lawyers, and such) use a S Corporation?
Yes. Note that the Wall Street Journal reported in the last presidential election that Democratic vice president candidate John Edwards saved roughly $750,000 in payroll taxes one year by practicing law as an S corporation. He split his over $26,500,000 of law firm profits into roughly $400,000 of salary and a leftover distributive share of $26,000,000.
Does a S Corporation complicate your accounting?
Well, not really. An S Corporation tax return often does need to include balance sheets, however. So that means you need to be using double-entry bookkeeping. Something like QuickBooks for Peachtree works fine.
Can you terminate the S Corporation status?
Yes, you can. You terminate the "S" status of a S Corporation intentionally by asking the IRS to revoke the S election. (This is how you convert a s corporation to a c corporation, if that's what you've decided to do.) And you can unintentionally or inadvertently terminate the S election by doing something that an S Corporation is prohibited from doing. I've mentioned elsewhere on this web page that basically only individuals can own shares in an S Corporation. If an S Corporation shareholder sells shares to a partnership or C corporation, that new ineligible shareholder may terminate the S election. (A common way this might happen is if an s corporation raises money from a venture capital fund, which would almost always be a partnership: At the point the s corporation issues the stock to the venture capital fund partnership, its subchapter s status terminates and the corporation converts from s status to c status.)
A couple of follow-up points should be made about intentional and unintentional S status terminations. First, if an S Corporation inadvertently goofs up its S status eligibility, prompt correction of the ineligibility and (if necessary) a little pleading with the IRS will often fix the problem. Second, if an S Corporation has multiple shareholders, the S Corporation should have a shareholder agreement that prohibits shareholders from doing things that terminate the Subchapter S status.
A related point: People commonly ask about conversions from s-corp to a c-corp status, but going from an s corporation to a corporation is probably something you should do only after consulting with a knowledgeable tax practitioner. You typically would not want to make a s to c corporation change or conversion unless you were forced to.
Who can be a S Corporation shareholder?
I've danced around this topic a few places on this web site because it becomes pretty complicated. But here's a bit more detail on who can and can't be an S Corporation shareholder...
Eligible S Corporation Shareholders
U.S. taxpayers and permanent residents, qualified subchapter S trusts, some voting trusts, testamentary trusts created by a will, grantor trusts, revocable trusts created as part of an estate, and certain exempt organizations.
Ineligible S Corporation Shareholders
Nonresident aliens, C corporations, partnerships, and foreign trusts.
Do you need an attorney's or accountant's help to set up an S Corporation?
If you're setting up a Subchapter S Corporation purely for tax reasons, I think you can do the setup yourself. Alternatively, you can use one of the many paralegal services available over the web.
If you're setting up the corporation or LLC (you can also use an LLC as an S Corporation), I observe that entrepreneurs and investors often feel like they get excellent value from spending the extra money on a good attorney who not only steps you through the process but also explains the liability protection.
How do states treat S corporations?
Great question. Unfortunately, the answer is a little complicated.
Perhaps the first thing to know, however, is that generally states treat S corporations the same way that the federal government treats S corporations. For example, if you make a valid S election with the IRS for federal income tax purposes, most often your state also honors that federal S election for state purposes. As another example, in general, S corporation shareholders are subject to state income taxes on their proportional shares of the S corporation's profit--just as they're subject to federal income taxes on their proportional shares of the S corporation's profit.
Numerous little exceptions to these general rules exist, however:
1. Some states do not recognize S corporations--in other words, they treat S Corporations like C corporations. At the time of this writing, the District of Columbia, New Hampshire, and Tennessee fall into this category. Note that you can still have an S corporation in these states--and that can still mean big federal tax savings--but the S corporation will only be an S corporation for federal tax purposes and not for state tax purposes. For state purposes, the corporation will be treated as a regular C corporation.
2. Some states tax S corporations on part of their income even though they do recognize the S corporation. For example, Massachusetts taxes S corporations on their profits when the profits rise about a specified limit. (Note: Shareholders in Massachusetts S corporations are not taxed on their shares of this "taxed" S corporation income.) And several other states tax shareholders on the S corporation's income and also tax the S corporation on some of its income. For example, in both Indiana and Kentucky, while shareholders get taxed on their proportional shares of the S corporation's profits (meaning the state has taxed all of the business's income), the S corporation also pays taxes again on capital gains and on excess passive income. Idaho, Maine and Wisconsin play a similar game with S corporations.
3. A small handful of states, including Michigan, California, New Jersey and New York, tax both the S corporation's profit... and the shareholder's proportional shares of the S corporation's profits. This means that in a sense the S corporation is double-taxed in a manner similar to a C corporation that distributes all of its profits as dividends.
Michigan, for example, taxes the S corporation shareholder on all of his or her income because Michigan does recognize the federal S corporation election for purposes of passing through S corporation profits to shareholders. Michigan also taxes the corporation on that same income via its single business tax. Fortunately, most small businesses--the sorts that would elect S corporation status--either aren't subject to the single business tax or don't pay very much single business tax. (At the time I'm writing this, a business is exempt from the single business tax if its gross receipts are less than $350,000.Michigan may just win the dubious honor of being the worst state in the nation to setup an S corporation.)
California, New York and New Jersey also tax both the corporation and the shareholder on business profits. Fortunately, in these three states, the state corporate tax rate levied on the S corporation's profits is modest. In California, for example, the S corporation tax is often a flat $800 a year.
4. In general, if an S corporation does business in another state (other than the home resident state), that other state will want to tax all shareholders--even nonresident shareholders--on their proportional shares of the S corporation's income earned in that other state. Some states as a convenience let the S corporation pay the income taxes owed by shareholders or nonresident shareholders.
As a final general comment about the state taxation of S corporations, let me suggest that if you want to turn an LLC into an S corporation or if you want to set up a new S corporation, it's a good idea to call the state income tax agency where the S corporation will operate and ask two questions: One, whether there's a separate state S corporation election form that needs to be filled out... and, two, if they have any information they can provide to you concerning the taxation of S corporations. You obviously don't want to be surprised.