The S Corporation is the second most popular entity chosen by small business owners. What makes this unique entity so appealing?
The S Corporation is a corporation that is given special-status for tax purposes. This special status allows it to be a pass-through entity for tax purposes and have the corporate advantage of limited liability. The S corporation has the same requirements as a C Corporation in its formation. It must have articles of incorporation, by-laws, elect directors, and keep minutes of corporate meetings. As stated in the C Corporation article, this requirement can be time-consuming and costly. The major advantage of the S Corporation is the limited liability of the owners. Just like a C Corporation, if the creditors seek repayment, they may only look to the S Corporation; they cannot look to the owners.
In order to receive the special-status an S Corporation must file a valid election timely on Form 2553 with the Internal Revenue Service. In order for the election to be considered filed timely, it must be filed on or before the fifteenth day of the third month of the taxable year. In most calendar basis tax entities, this date is March 15th. Other restrictions of an S Corporation are that it may have no more than 100 shareholders, have only one class of stock, and S status must be elected by all the shareholders.
The tax treatment of an S Corporation is unique. An S Corporation is taxed similar to a partnership, in that all of the income, deductions, and other items are allocated to the owners. Thus you have a single layer of tax applied to the earnings. However, the income, deductions, and other items must be pro-rata allocated based on their ownership; unlike the Partnership which may specifically allocate income, deductions, and other items to individuals owners. The S Corporation reports its earnings and how those earnings are allocated on Internal Revenue Form 1120S.
The income allocated from the S Corporation to its owners is not subject to self-employment tax since the S Corporation is considered a separate entity. The owners may be employees of the S Corporation in which they may be paid a wage, which is subject to payroll taxes just like any other employee. One item of contention is that that the Internal Revenue Service requires that if an owner is working for the S Corporation, the owner’s salary be reasonable. The definition of “reasonable salary” has been the subject of many court cases in the past. The S Corporation, like C Corporations, can exclude the value of fringe benefits provided to employees only if the employee owns less than two percent of the outstanding stock. If the employee owns more than two percent, the fringe benefits provided by the S Corporation are subject to special tax treatment.
To illustrate how S Corporations work and how the income passes through to the owners let us go back to the same example.
John Doe is 100% owner of John Doe S Corporation. During tax year ending 2015 his S Corporation earns $75,000. He is filing single.
Since the S Corporation is a conduit entity and the earnings passes through to the owners, the following illustrates how John Doe would report it:
This treatment is exactly identical to how a partnership would be reported except that the earnings from S Corporations are not considered self-employment income. Therefore, unlike Partnerships, there are no self-employment taxes due.
As we stated earlier, if the owner is 100% owner and an employee of the business he would be required to pay himself a reasonable salary. Let us assume for the field that John Doe is in, a reasonable salary would be $40,000. As any employee, he would be required to withhold the necessary federal and state income tax, plus pay the employee share of social security and Medicare taxes. If the S Corporation paid him $40,000 salary, the operating income from the S Corporation would be:
Since John Doe is an employee and 100% owner of the S Corporation, he would report the following the earning from the S Corporation as follows:
As you can see from the previous articles, each entity has its own set of rules and the tax consequence to the owners varies from entity to entity. What is the best entity for you is a decision that you should discuss with a tax professional.
Zebee Levet is a CPA with Roy L. Cress CPA, Inc. in Charlottesville, VA. With 30 years of experience she has specialized in the area of tax and tax resolution. She has also been a Quickbooks Proadvisor since 1997. She and her husband currently live on a 10 acre farm located in Troy, VA.