One of the most common misunderstanding/misconceptions I run into in the business world is the nature and role of S-Corps. Most small businessmen know that there is such an animal as an S-Corp, but they don’t really know what it looks like or what it does. In fact, I often hear a business owner proclaim that their accountant (or sometimes, but rarely, their lawyer) has changed their company from an LLC to an S-Corp. That is actually almost never the case. The blame for this confusion lies primarily with us lawyers and accountants, who frequently fail to properly educate our clients. Usually this doesn’t result in any kind of real business disaster (although in some cases it could), but it can nevertheless be very confusing. I’m going to take a few minutes to try and bring a little clarity to the S-Corp.
Initially, we need to understand the difference between the legal form of an entity, and the way an entity is viewed, and thus taxed, by the I.R.S. The two are not necessarily the same. In other words, a business entity (company) can take one legal form, but be taxed like a totally different type of legal entity. Specifically, when we speak of S-Corps, we are exclusively speaking of the way a business is taxed, not its legal form. This is evident from it’s very name: it’s called an S-Corp because it is taxed under Subsection S of the Internal Revenue Code (IRC). Likewise, a C-Corp is called that because it is taxed under Subsection C of the IRC. More on this in a moment.
The confusing thing is that businesses which are not corporations at all can be taxed like corporations. For instance, an LLC is not a corporation, and is usually treated by the IRS as a partnership, and is therefore by default taxed like a partnership. However, an LLC can (and more often than not should) choose to be taxed like an S-Corp, to lower the members’ tax burden. Legally, it still remains an LLC, but as far as the IRS is concerned, it will be taxed like an S-Corp.
So, what does that actually mean, to be taxed like an S-Corp? To understand that, we first need to understand what it means to be taxed like a C-Corp and a partnership (LLC). C-Corps are subject to what we call “double taxation.” This is exactly what it sounds like: the corporate income is taxed twice. Initially, when the corporation receives income, the corporation pays income taxes on that money, at a tax rate anywhere from 15% to 38% (depending on amount of income). Then, when the company pays out its profits as dividends or distributions, the value of those dividends or distributions is taxed again as income to whomever received it — usually a stockholder — at whatever individual tax bracket that recipient falls into (anywhere from 10% to 39.6%). So, for example, if a C-Corp made $200,000 in income, it would pay just north of $61,000 in company income tax, leaving $139,000 in net profit. If it chooses to distribute all of that to its sole shareholder, that individual would pay an additional $37,500 (roughly) in personal income taxes. That’s a total tax burden of approximately $98,500 — close to 50% of its income!
Conversely, an LLC is taxed like a partnership. A partnership almost never gets taxed at the company level — the profits of the partnership are divided among the partners, and the individual partners pay income tax on it on their personal tax returns. This is what we call “flow-through taxation,” because the income “flows through” the company without getting taxed until it gets to the individual. That sounds like a great deal — no corporate tax, and thus no double taxation! — except that in addition to paying the income tax, a partner will also usually pay self-employment taxes on that same money, which as of the date of this writing is approximately 15.3%. So, for example, if our LLC made $200,000 in income, the company would pay no income tax whatsoever — $0. However, the sole member would pay approximately $30,600 in self-employment taxes on the entire amount, and another $42,800 (roughly) in income taxes on the entire amount, for a whopping $73,400 in taxes. Not as bad as the C-Corp, but still a lot of tax.
Electing S-Corp tax status enables a business to take advantage of “flow-through” taxation (eliminating the double tax of a C-Corp), but can also eliminate the self-employment tax on dividends and distributions, if the owners pay themselves a reasonable salary, and pay payroll taxes on that salary. If the sole owner of a company — it doesn’t matter whether it’s a corporation or an LLC — elects S-Corp tax treatment, but takes no other steps, and simply pays himself or herself out of dividends and distributions, then he or she will be subject to the same self-employment tax as our sample LLC above. However, let’s say our company again makes $200,000, and has elected S-Corp tax treatment. If the sole owner pays himself or herself, say, $50,000 as a reasonable salary (this amount can vary, depending on the business the S-Corp is in, and what the owner actually does in furtherance of the business), and pays himself or herself the remaining $150,000 in dividends or distributions, he or she will pay about $7,650 in payroll taxes (Social Security and Medicare, etc.), plus just over $42,800 in income taxes, for a final tax bill of approximately $50,500. That’s a tax savings of nearly $23,000 — reducing the tax bill by approximately 30%.
So, our last company elected S-Corp tax status, saving itself a heap of taxes, and all the while remaining an LLC. Cool, huh?
Be aware that not all businesses can qualify to elect S-Corp tax treatment. Among other things, the business may only have a maximum of 100 members or shareholders, and they must only consist of individuals, certain trusts and estates, or another S-Corp. If the business is actually a corporation, it can only have one class of stock; in other words, it cannot have any class(es) of preferred stock. However, for those businesses which qualify, it frequently makes sense to elect S-Corp tax status, in order to reduce the total tax burden of the business and its owners.
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