Understanding how your business structure is taxed is critical to ensuring you are making the most of your tax advantages. S corp tax benefits are pretty great if you can qualify, especially for small businesses. Here’s a rundown of what they are and how to take advantage of S corp status.
A brief overview of S corp taxation
What is an S corp?
S corporation (or Subchapter S) is a special tax status granted by the IRS to eligible small businesses.
Businesses that elect S corp status have various advantages of a C corporation combined with the favorable tax treatment of a partnership. S corp owners can also enjoy many of the same legal protections along with some important tax benefits.
Difference between S corp vs LLC vs C corp
The key difference between C-corp and an S-corp lies in tax treatment. In C corporations, corporate income is taxed at the corporate level, whereas in S-corporations it is taxed at the shareholder level.
There are a few key differences between LLCs and S corps when it comes to taxes. S corps can avoid the double taxation that LLCs might face since the taxation of LLCs depends on the number of members in the entity.
As a single-member LLC owner, you have the responsibility to fulfilled taxation as a sole proprietorship (unless it files a form to elect the tax status), whereas a multiple-member LLC will be subject to partnership tax.
The main difference between these two types of taxation is that a partnership has an additional obligation to file partnership annual information returns to the IRS, while a sole proprietorship file a personal income tax return.
As you can see, the tax benefits of S corp are quite notable. Being qualified for S corp status, however, requires you to meet stringent eligibility requirements.
- Be a domestic corporation
- Have only allowable shareholders, which generally include individuals, certain trusts, and estates
- Have no more than 100 shareholders
- Have only one class of stock
Need a detailed guide to the benefits and drawbacks of an S corporation? Check out our blog article.
S corp tax treatment and benefits
Pass-through entity (save money on corporate taxes)
Taking a closer look at the term “double taxation” is a good idea for understanding the taxation treatment of the default corporation (if you do not elect to become an S corporation, you are automatically given a C corporation).
“Double taxation” refers to the fact that C corporation income is taxed twice: first at the corporate level when profits are earned, and again at the shareholder level when dividends are distributed. This can result in a higher overall tax burden than if the business were structured as an S corporation.
How can S corp tax savings offset this disadvantage?
S corps are “pass-through” entities, meaning that the business itself is not subject to income tax. Instead, the income or losses of the S corp are “passed through” to the shareholders and reported on their individual tax returns. This can save S corp owners a significant amount in taxes, as they’ll only be taxed on their personal income tax rate (which is generally lower than the corporate tax rate).
Let’s say you initially incorporate a C corporation. As a result of electing to become S-Corps through the IRS, your entity will be exempt from paying corporate income taxes, and instead, the business income “passes through” to the shareholders for federal tax purposes. The shareholders must then report this income (along with any other personal income) on their individual tax returns.
Despite some S corp tax benefits, S corps are still required to pay taxes on certain types of income. S corps must pay taxes on built-in gains and passive income in some cases. S-Corps can also be subject to the alternative minimum tax.
Find Certain Instances That Can Make S Corp Subject To CIT with our next parts!
Not subject to self-employment tax (save money on personal taxes)
Employees who qualify as having earned income must be subject to payroll taxes (and/or self-employment taxes under the IRS rule), then S corp status can save business owners money. But how?
According to the IRS, payroll taxes for corporation owners are a total of 15.3%, which includes Social Security and Medicare taxes, apart from federal and state income taxes.
Commonly half of the must-paid payroll tax is paid by the employer and half by the employee. Meanwhile, the self-employment tax rate in the USA, applied for individuals who work for themselves without having an employer withhold money from their paycheck and send it to the IRS, is currently 15.3% of net earnings.
As an S corporation, you can choose to pay shareholders either salary or dividends and this helps lower their personal income tax.
The advantage of paying dividends is that they are not subject to S corp self-employment tax and FICA taxes such as 6.2% Social Security tax and 1.45% Medicare tax on earnings. To shed light on, shareholders with amounts received as dividends are free from paying self-employment taxes on items passed through the corporation. This is because such dividend distributions from the S corp are generally not considered compensation, so treated as ordinary income; hence, they must pay only income taxes at the federal and state levels.
Be advised that S corp shareholders can enjoy tax-free dividends if the dividend distribution does not exceed their stock basis in the S corporation. If it does exceed the shareholder’s basis, then the distribution is taxed as a capital gain.
On the other hand, by characterizing the self-employed owner as a corporate employee, S corp owners that pay themselves a “reasonable” salary must submit the personal income tax, FICA taxes, and unemployment tax the same as that on other employees. This approach, however, can save the company money on taxes (for tax deduction purposes).
S corporation status can be a great way to save on personal income taxes as well, but you need to make sure to consult with your tax professionals to determine which option is best for your business.
S corporation may be subject to the corporate income tax
S corporations are generally not subject to corporate income tax. However, there are certain instances where an S corporation may be subject to the corporate income tax.
For example, if an S corporation has more than one class of stock, or if they engage in certain types of business activities, such as insurance or banking. When your business entity does not qualify for S corporation status, it will be taxed as a C corporation.
S corporations may also be subject to the corporate income tax if it has accumulated earnings and profits from prior years when it was C corporation. The accumulated earnings tax (AET) is imposed on S corporations that have accumulated earnings and profits in excess of what is necessary for the reasonable needs of the business. The tax rate applied is 20%.
The built-in gains (BIG) tax applies to C corps that elect to become an S corporation. When a C corporation converts to an S corporation, any unrealized built-in gains on the corporation’s assets over a five-year period since the first day of the S corp’s first tax year are subject to taxation. The BIG tax is imposed at 21%, equal to the corporate income tax rate.
S corporations with accumulated earnings and profits exceeding 25% of gross receipts from S corporation’s non-passive income for the tax year, may be subject to the federal corporate income tax on some or all of their passive investment income. Passive investment income is income generated from investments that are not related to the company’s main line of business. This could include things like interest from a savings account or dividends from stocks.
Tax filing requirements for an S Corporation
S corporations are subject to different tax rules than other types of businesses, so it’s important to understand the tax payment and filing requirements before you select to become an S corp.
- File US income tax returns
S corporations must file Form 1120S, “U.S. Income Tax Return for an S Corporation,” and provide each shareholder with a Schedule K-1 every year. This form is used to report the income, losses, and dividends of the S corporation. It is due by the 15th day of the 3rd month after the end of the S corporation’s tax year. S corporations use a calendar year as their tax year, unless they file for a different tax year with the IRS.
- File quarterly Estimated Tax
S corporations must make quarterly estimated tax payments (Form 1120-W) if they expect to owe more than $500 in taxes for the year. Estimated tax payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the S corporation’s tax year.
If you are an S corporation shareholder and you receive wages from the S corporation, you may have to pay estimated tax (1040-ES). This is the tax you expect to owe for the current year after subtracting any withholding and refundable credits.
- File federal quarterly tax return
As an S corporation employer, you’ll need to file a quarterly payroll tax return (IRS Form 941 – Employer’s Quarterly Federal Tax Return) to report S corp taxes withheld from their paychecks. This is in addition to your annual corporate tax return.
How to apply for S corp status
S corporations are only available to certain types of businesses, so you’ll need to make sure your business qualifies to apply for this type of business structure. You’ll then need to file articles of incorporation with your state to create your corporation and set forth its purpose. Filing Form 2553 with the IRS is a must to elect S corporation status for your company. Once you’re an S corporation, you’ll need to follow certain rules and regulations in order to maintain your status.
Check out specific steps to obtain S Corp status for your reference.
There are many S corp tax benefits that can be helpful for your businesses. Some of the key benefits include the ability to avoid double taxation, the flexibility to distribute profits and losses as you see fit, and the potential to save on self-employment taxes. These benefits can help you save money on taxes, which can be a big help when you are trying to run a successful business.
However, it is important to remember that these benefits come with some responsibilities. Make sure that you understand all of the requirements before you choose to form an S corporation. This will help you avoid any problems down the road.
Need more practical advice on how to set up your US company? Feel free to chat with our consultants.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
- A brief overview of S corp taxation
- S corp tax treatment and benefits
- S corporation may be subject to the corporate income tax
- Tax filing requirements for an S Corporation
- How to apply for S corp status
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