S Corp Double Taxation: Everything You Need to Know
S Corp double taxation is something that doesn’t occur, as only a C Corp is subject to the double tax implication.3 min read
2. Avoiding Double Taxation
3. Simplified Tax Filing
4. S Corp Qualification Status
S Corp double taxation is something that doesn’t occur, as only a C Corp is subject to the double tax implication. This means that C Corps must pay corporate income tax on all profits. The profits are then taxed again at the personal level if distributions are made to the C Corp shareholders. However, while C Corporations generally operate as separate and distinct entities from its owners, S Corps do not, as they are a sub-set of corporations. As such, they are not subject to double taxation.
S Corp: An Overview
Created in 1958, S Corps, also referred to as Sub-S Corporations, operate under Subchapter S of Title 1 of the Internal Revenue Code.
S Corps operate as pass-through tax entities, which means that the profits and losses of the business pass through to the owners who report it on their personal tax returns. Therefore, the S Corp shareholder must report a percentage of the profits and losses on their personal income tax returns even if they don’t receive that money in the form of a distribution.
However, if a shareholder does in fact receive a distribution, i.e. dividend, the money isn’t subject to self-employment tax. If the money is paid to a shareholder in the form of wages, then that money is taxable. This is one of the ways in which S Corp shareholders try to minimize their taxes.
Keep in mind that a Limited Liability Company (LLC) can also elect to be taxed as an S Corp. Since an LLC isn’t recognized as a legal entity in most states, it must elect to be taxed as either a partnership, C Corp, or S Corp. While an LLC already operates as a pass-through tax entity, the reason why an LLC would elect to be treated as an S Corp is due to the ability for the LLC members to divide the business earnings into salary and distributions. That way, the LLC member can receive a reasonable compensation while also earning dividends and not being subject to self-employment taxes through those dividend payments.
Avoiding Double Taxation
The S Corp and LLC are two of the most common and favorable business structures for small businesses, since both avoid double taxation. LLCs and S Corps are taxed more like a sole proprietorship or partnership as opposed to a C Corp, which is taxed as a separate entity from its owners. This means that the S Corp doesn’t pay taxes at the corporate level. As previously noted, all profits and losses are paid by the owners on their personal income tax returns.
Personal tax rates are generally lower than corporate rates, which means that S Corps usually pay less taxes than C Corps. The difference between S and C Corp taxation isn’t the percentage of income that is taxed, but instead where it is taxed, i.e. wages or distributions.
If you own 50 percent of an S Corp, then you’ll have to report 50 percent of the company’s profits on your personal tax return. However, if you own 50 percent of a C Corp, your taxes might differ greatly depending on how much compensation and dividends you were paid. C Corp dividends are taxed along with wages paid to the C Corp shareholder.
Simplified Tax Filing
One of the key benefits of the S Corp is the simplified process for tax filing. Again, since the S Corp doesn’t have to file federal taxes, a separate corporate tax return isn’t necessary. However, if you are an owner in an S Corp, you might have to file several forms along with your personal return (Form 1040). This could include separate forms if you receive both S Corp proceeds as well as C Corp dividends. You might also need to pay quarterly taxes on your personal tax return, particularly if you don’t have enough funds being taken out of your paycheck.
S Corp Qualification Status
Not all businesses qualify for S Corp status, as the IRS has the following requirements:
- The business must operate as a domestic corporation.
- The shareholders can’t be partnerships, corporations, or non-resident aliens.
- There can’t be more than 100 shareholders.
- Only one class of stock is allowed.
- The business has to be eligible, i.e. some banks and insurance companies aren’t eligible.
If you need help learning more about forming an S Corp and the other benefits of operating an S Corp, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.