When planning an S corporation, taxes are important for a business owner to understand. Similar to a regular corporation, an S corporation pays taxes, but on an individual shareholder's tax form. S corporations are pass-through entities wherein a corporation's taxes are filed on the shareholder level to avoid double taxation.

Dual Tax Burden of S Corporations

The S corporation is one of the fastest growing pass-through types of business. Pass-through entities pass income to the shareholders, who settle taxes on the personal level. S corporations are limited to less than 100 shareholders. These shareholders are US citizens or residents, and the business is not owned by different businesses.

Like other pass-through owners, shareholders of an S corporation get the same marginal tax rates as wage earners. Moreover, the shareholders might pay different taxes depending on their participation in the business. Taxes that S corporation shareholders need to settle include the federal individual tax (maximum of 39.6 per cent), state and local taxes (about 0 to 13.3 per cent), and the Pease limitation on itemized deductions, which comes with an additional 1.18 percent marginal tax.

A shareholder's status on the payroll greatly affects the tax and payroll, all depending on their participation in the day-to-day operations of the business. There are two types of shareholders:

  1. Active shareholders. Most active shareholders receive wage income and a profit distribution from an S corporation. A payroll tax of 15.3% is applied on the first $117,000 of the wage income, 2.9% on the next $83,000, and 3.8% for income over $200,000. Distribution income, on the other hand, is not subjected to a payroll tax. Given that one can allocate more on his distribution income than on his wage income, the Internal Revenue Services (IRS) sets guidelines for business. Businesses are required to pay a realistic salary to their active owners. Active shareholders can have varied top marginal tax rates that depend on whether the last dollar is profit or wage.
  2. Passive shareholders. Unlike active shareholders, passive ones are not paying payroll tax since they don't earn wage income from the business. However, they are required to settle a 3.8% Affordable Care Act (ACA) Net Investment Income Tax when income is over $200,000 ($250,000 if filing jointly as married individuals.) This means that passive shareholders might have higher top marginal tax rates than active shareholders.

S Corporation Taxation

Corporations in the United States have the option to either pay their taxes at the corporate or shareholder level. If a corporation chooses to pay its tax on the corporate level, the treatment is called a C corporation. The corporation files corporate tax returns, calculates its taxable income, and computes its tax using corporate tax rates. By the time a C corporation distributes income to the shareholders in the form of dividends, the dividends will be included and are taxable at the shareholder level.

On the other hand, corporations can file taxes on the shareholder level. This is an S corporation, with the term taken from the Internal Revenue Code with the letter S from subchapter S of Chapter 1. In this way, taxable income, together with a few deductions and other tax credits, is distributed to the shareholders. Shareholders will then include these distributions as part of their personal tax return. No tax is applied to the corporate level because personal tax rates are applied to all items of income.

General Features of S Corporations

Major features of an S corporation include:

  1. Corporations use S corporation to pass all income, losses, and other deductions and credits to the shareholders for federal tax purposes.
  2. Shareholders of S corporations are charged with reporting the flow of income and losses on their individual tax rates.
  3. S corporations avoid double taxation with the pass-through of income and losses from the corporate level to the shareholder level.
  4. Tax on passive income and certain built-in gains on the entity level is an S corporation's responsibility.

Risks of S-Corporations

Since the concept of S corporation can easily be abused by some entities, the IRS strictly monitors corporation returns. If you try to avoid hefty self-employment taxes by declaring $20,000 as salary income out of $500,000 annual income, then you might trigger an IRS inquiry. Submitting reasonable numbers for your wages and distributions can help move you away from a possible IRS audit and avoid potential penalties and risks.

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