Experienced Tax
Accountant – As a small business owner,
figuring out which form of business structure to use when you started was one
of the most important decisions you had to make; however, it's always a good
idea to periodically revisit that decision as your business grows. For example,
as a sole proprietor, you must pay a self-employment tax rate of 15.3% in
addition to your individual tax rate; however, if you were to revise your
business structure to become a corporation and elect S-Corporation status you
could take advantage of a lower tax rate.
What
is an S-Corporation?
An
S-Corporation (or S-Corp) is a regular corporation whose owners elect to pass
corporate income, losses, deductions, and credits through to their shareholders
for federal tax (and sometimes state) purposes. That is, an S-corporation is a
corporation or a limited liability company that's made a Subchapter S election
(so named after a chapter of the tax code). Rather than a business entity per
se, it is a type of tax classification. Shareholders then report the flow-through
of income and losses on their personal tax returns and are assessed tax at
their individual income tax rates, which allows S-corporations to avoid double
taxation on corporate income. S-corporations are, however, responsible for tax
on certain built-in gains and passive income at the entity level.
To
qualify for S-corporation status, the corporation must submit a Form 2553,
Election by a Small Business Corporation to the IRS, signed by all the
shareholders, and meet the following requirements:
- Be a
domestic corporation
- Have
only allowable shareholders. Shareholders may be individuals, certain trusts,
and estates but may not be partnerships, corporations or non-resident alien
shareholders.
- Have
no more than 100 shareholders
- Have
only one class of stock
- Not
be an ineligible corporation (i.e. certain financial institutions, insurance
companies, and domestic international sales corporations).
- What
are the Tax Advantages of an S-Corp?
- Personal
Income and Employment Tax Savings
S-corporation
owners can choose to receive both a salary from the corporation and nondividend
distributions, which are earnings and profits that pass through the corporation
to you as an owner, not as an employee in compensation for your services, and
are tax-free. Because their compensation is less than it would be if they were
operating a sole proprietorship, for example, S-corp owners save on Social
Security and Medicare taxes.
The
split between salary and distributions must be "reasonable" in the
eyes of the IRS, however. Paying self-employment tax on 50 percent or less of
profits or a salary that is in line with similar businesses is one example.
Most
S-corporation distributions are non-dividend distributions; however, dividend
distributions can occur in a company that was previously a C-corporation or
acquired C-corporation attributes in a non-taxable transaction (i.e., merger,
reorganization, QSub election, etc.). These dividends are taxed at a lower rate
than self-employment income, which lowers taxable income.
Finally,
some S-corp owners may be able to take advantage of the Qualified Business
Income Deduction for pass-through entities as well, thanks to tax reform.
Losses
are Deductible
As a
corporation, profits and losses are allocated between the owners based on the
percentage of ownership or number of shares held. If the S-corporation loses
money, these losses are deductible on the shareholder's individual tax return.
For example, if you and another person are the owners and the corporation's
losses amount to $20,000, each shareholder can take $10,000 as a deduction on
their tax return.
No
Corporate Income Tax
Although
S-corps are corporations, there is no corporate income tax because business
income is passed through to the owners instead of being taxed at the corporate
rate, thereby avoiding the double taxation issue, which occurs when dividend
income is taxed at both the corporate level and at the shareholder level.
Less
Risk of Audit
In
2017, S-corps faced an audit risk of just 0.2% compared to Schedule C filers
with gross receipts of $100,000 who faced an audit rate of 0.9% (2018 IRS Data
Book). While still low, individuals filing Schedule C (Profit or Loss from
Business) are at higher risk of being audited due to IRS concerns about small
business owners underreporting income or taking deductions they shouldn't be.
Help
is just a phone call away.
Whether
you keep your existing structure or decide to change it to a different one,
keep in mind that your decision should always be based on the specific needs
and practices of the business. Don't hesitate to call the office if you have
any questions about electing S-Corporation status or are wondering whether it's
time to choose a different business entity altogether.
Amare Berhie, Senior Accountant
(651) 300-4777
