Should you decide to incorporate your business, you’ll need to decide which type of corporation you want your business operating under for tax purposes. While there are several viable business structures from which to choose, your choices will likely come down to a Limited Liability Company (LLC), a C Corporation or an S Corporation. For the purposes of this discussion, we would like to point out the benefits of filing taxes under S Corporate status.
What is an S Corporate Structure
As a point of reference, it is important to note that S Corporation status is not a legal designation, it’s a tax filing designation. The business owner would legally set up their business as a Corporation and subsequently, file for S Corporate tax filing status with the Internal Revenue Service (IRS). After approval of S Corp filing status by the IRS, the corporation would then be allowed to file taxes as though it is operating as a partnership.
To qualify for S Corporate status, also referred to as Sub-chapter S status, the corporate organization must be a domestic entity (incorporated in the US) with 100 or fewer qualified shareholders and only a single class of available shares. Qualified shareholders would include individuals, specific trusts and estates, plus certain tax-exempt organizations (501(c)(3)), also known as charitable or nonprofit organizations. Nonresident individuals, corporations and partnerships would not qualify as shareholders and would disqualify the company from S Corp status.
Tax Benefits Associated With S Corp Status
If a certain tax filing status can offer real tax benefits to an organization, it’s something business owners have to closely consider. At this point, we would like to focus this discussion on two primary tax benefits offered by the S Corporate tax filing status. The first benefit involves the corporate tax filing process while the second benefit involves employment tax liability at both the corporate and individual levels.
Paying of Corporate Taxes
As a C Corporation, a company is required to pay corporate taxes based on IRS guidelines. When the corporation pays dividends to shareholders, the shareholders are then required to pay individual taxes on their dividend income. Financial experts often refer to this taxation process as a system of double taxation.
According to the Investopedia.com website, double taxation is defined as: “a tax principle referring to income taxes paid twice on the same source of income. It can occur when income is taxed at both the corporate level and personal level.”
Clearly, this form of taxation benefits the IRS. However, it’s not to the benefit of a smaller corporation. This is why so many qualifying corporations will apply for S Corp status. It provides them with a way to avoid corporate taxes and improve both profitability and cash flow.
For the shareholders who receive dividends, they simply pay taxes on the dividends they receive. Ultimately, they will be required to pay taxes on their proportionate share of corporate dividends based on their proportionate share of stock ownership. In other words, a shareholder who owns 50% of a corporation’s stock will be responsible for paying income taxes on 50% of the dividends paid by the corporation.
Lowering Employment Tax Liability
When electing to use S Corporate tax filing status, a business owner will typically want to look beyond the tax benefits afforded to the corporation. They are well within their rights to also consider the effects on their personal tax filing status.
Acting as an employee with standard forms of compensation (salary, bonus, commission), the individual has a responsibility to pay employment taxes with FICA being the predominant tax levied by the IRS. The current (2020) statutory FICA rate for individuals stands at 7.65% with 6.2% being allocated to social security and 1.45% being allocated to Medicare. In addition to what the employee pays, the employer is responsible for paying the same 7.65% to the IRS on the employee’s behalf.
If a business owner successfully secures S Corp filing status, they can effectively avoid some employment taxes by taking a portion of their compensation in the form of dividends, which is not subject to FICA taxes. That’s a 7.65% savings at the individual level and another 7.65% savings for the corporation.
Of course, the IRS does place limits on this type of activity. If an employee is also a shareholder, they may be required to take some portion of their compensation as salary, which is subject to the employment taxes. According to IRS guidelines, the distribution between dividends and wages must be reasonable. Anything not deemed reasonable by the IRS could be viewed as income tax avoidance.
Conclusion
If a business wants to qualify for and maintain S Corp filing status, there are a lot of rules to which the corporation must adhere. That’s why consultation with tax experts is so important. One error can result in disqualification, which might then result in far-reaching ramifications.
As a professional accounting firm, we make it our business to keep our accountants educated about the available tax filing options. If a client enlists our services, we want to make sure they can avail themselves of any tax advantages to which they might be eligible. We also want to make sure our clients maintain 100% compliance with any tax laws set forth by the IRS now and in the future.
