Electing to be an S-Corporation: The Business Entity Combo
Updated: Dec 7, 2021
For an S-corporation, you can basically see the character of almost of every business entity, such as sole proprietorship, partnership, and Corporation. An S-corp is a corporation that is taxed like a sole proprietorship if there is only one shareholder, or a partnership if there are two or more shareholders. Same as an LLC, the S-corp itself does not pay any tax, but the profits are passed on to the shareholders, and then the shareholder reports the income on their individual income tax returns. In addition, the tax benefit of S-corp avoids the double tax as C-corp. Does S-corp sound like a perfect business entity in the world? However, there are some drawbacks of being an S-corp. An S-corp only allows a maximum of 100 shareholders and all of them must be U.S citizen or resident aliens. Since the flow-through taxes will be paid at the personal level, so the high-income shareholders will pay more taxes on their distribution. Finally, it not suitable to hold as appreciating the investment. Capital gain on sales of the asset will incur higher taxes than with other pass-through entities, such as LLCs or limited partnership.
There is no perfect shoe fitted for everyone’s feet. We, as a human being, should always choose something that is suitable based on what you are and what you want to be. Therefore, if you found an S-corp is suitable for your current business and development goal, go for it. If not, you can stay as your current business entity. In this article, we will learn about the S-corp election, structure of an S-corp, and the tax prospect of an S-corp.
If your current business entity is a corporation, you don’t need to do anything. In order to taxed as an S-corp, you need to notify the IRS that you are choosing to have it taxed as an S-corp. In the tax term, it is called “check the box”.
If your business entity is other than a corporation, you need to use Form 2553 to file this election. Small Business Corporation provides the IRS with detailed information about the corporation requesting S-corp status and about the corporation's eligibility for electing this status. The IRS requires that the Sub-chapter S Election be filed no more than two months and 15 days after the beginning of the tax year the election is to take effect. For a startup, this means the first year of the business. If your business starts on January 7, you must file the S-corp election no later than March 15. Failing to file means you will not receive the S-corp status for that tax year. However, S-corp status is allowed only if the entity has no more than 100 shareholders, none of the entity's shareholders are nonresident aliens—that is, noncitizens who don’t live in the U.S, the entity has only one class of stock—for example, there can’t be preferred stock giving some shareholders special rights, and one of the entity's shareholders are other corporations or partnerships.
An S-corp has the same liability protection as a corporation. Because an S-corp is a corporation, it retains the separate entity protection of a corporation, and the corporate shield of protection against liabilities protects the owners from lawsuits or responsibility for debts of the corporation, in many cases. Of course, this liability protection is not absolute, and it can be broken if owners personally guarantee loans, or if owners commit acts which include them in responsibility for actions of the corporation.
Although S-corp is a corporation, it doesn’t have double taxation. A corporation pays corporate income tax on its profits, then the owners are taxed on the dividends they receive (from the profits), resulting in double taxation. In an S-corp, on the other hand, the corporation doesn't pay income tax; the owners pay income taxes based on their respective shares of the profits.
If the S-corp has a loss, each owner's share of that loss is passed through to the individual income tax return. If the owner has other income, the loss can reduce all or part of that income.
How S-Corp is Taxed
Same as a partnership, an S corp is a pass-through entity—income and losses pass through the corporation to its owners’ personal tax returns. S-corps also report their income and deductions much like partnerships. S-corp files an information return (Form 1120S) reporting the corporation’s income, deductions, profits, losses, and tax credits for the year.
Shareholders must be provided a Schedule K-1 listing their shares of the items on the corporation’s Form 1120S. The shareholders file Schedule E with their personal tax returns (Form 1040) showing their share of corporation income or losses.
The deference from a partnership is that the employment status of owners who can work in the business. The owner of an LLC taxed as a partnership is not an employee of the LLC for tax purposes. He or she is simply a business owner. In effect, an active owner in an S-corp wears at least two hats: as a shareholder (owner) of the entity, and as an employee of that entity. However, an owner/employee must be compensated for his or her services with a reasonable salary and any other employee compensation the corporation wants to provide.
The owner/employee must report any S-corp earnings on his or her personal income tax return, and pay his or her share of Social Security and Medicare taxes on any employee salary paid. The corporation must withhold federal income and employment tax from the owner/employee’s pay, and pay state and federal unemployment taxes and Social Security and Medicare taxes on the employee’s behalf.
The Social Security and Medicare tax rate for an employee is the same as for a self-employed business owner; however, it’s paid differently. Half the total tax is deducted by the employer from the employee’s pay, and half is paid by the employer itself. When you own the business that is paying these taxes, it makes no practical difference that half is paid by the employer—you are the employer.
For example, John forms an LLC to operate his construction business and elects to have it taxed as an S-corp. John is an employee of the LLC and receives a $100,000 salary. The remaining $100,000 of the business's profits are passed through the S-corp and reported as an S-corp distribution on John’s personal income tax return, not as employee salary. Because it is not viewed as employee wages, neither John nor his corporation needs to pay Social Security or Medicare tax on this amount. John and his corporation only pay a total of $15,300 in employment taxes (15.3% x $100,000 = $15,300). Had John not elected S-corp status for his LLC, he would have had to pay self-employment tax on his entire $200,000 profit. This would have required him to pay an additional $2,900 in Medicare taxes and $1,252 in Social Security taxes.
What if you take no salary at all and take all benefit as distribution in a tax-free way, so you would not owe any Social Security and Medicare taxes. As you might expect, however, this is not allowed. The IRS requires S-corp shareholder-employees to pay themselves a reasonable salary—at least what other businesses pay for similar services.
Bonus Section: Pass-Through Tax Deduction – The Tax Cuts and Job Act
For sole proprietorship, partnership, LLCs, and S-corp owners, they may deduct up to 20% of their net business income from their income taxes starting 2018. This is a personal deduction all pass-through business owners may take whether or not they itemize.
You are qualified for the 20% deduction only if your total taxable income for the year is less than $157,500 (single) or $315,000 (married, filing jointly). If your taxable income is greater than $207,500 (single) or $415,000 (married), you don’t qualify for the pass-through deduction unless your business pays employee wages or has business property.
Referring to the previous example, John earned $500,000 in profit from his business, and that the business has no depreciable property. At this income level, his pass-through deduction is limited to the greater of (1) 50% of W2 wages paid by the business, or (2) 25% of wages plus 2.5% of the cost of business property. John works as an employee of his business and pays himself a salary of $200,000. He qualifies for a pass-through deduction of $100,000 (50% x $200,000 = $100,000). Had John not elected S-corp status, his business would have paid no W2 wages to employees and he would have not qualified for any pass-through deduction.
Unfortunately, the strategy outlined above doesn’t work if you are involved in a personal service business, such as accounting, law, health, consulting, athletics, financial services, and brokerage services. The pass-through deduction is not available for such businesses where the owner’s taxable income is over $415,000 (married, filing jointly) or $207,500 (single). The pass-through deduction is gradually phased out for these taxpayers when their taxable income exceeds the $315,000/$157,500 thresholds. This is intended to prevent highly compensated employees who provide personal services—lawyers, for example--from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction.