S Corp Tax Rules: Everything You Need to Know
S corp tax rules are more flexible than C corps. The tax treatment of your business is one of the most important factors to consider. First, you need to be aware of various entities that include sole proprietorships, partnerships, and LLCs. The entity you choose will determine the amount of taxes you pay.4 min read
2. S Corp Limitations
3. Individual Taxes
4. Corporate Taxation
5. S Corp Benefits
S corp tax rules are more flexible than C corps. The tax treatment of your business is one of the most important factors to consider. First, you need to be aware of various entities that include sole proprietorships, partnerships, and LLCs. The entity you choose will determine the amount of taxes you pay.
• Sole Proprietorship: This is the easiest type of business entity to register. You would not file a different tax return like other entities. Rather, business income would be noted on Form 1040, Schedule C.
• Partnership: This entity comprises a group of two or more people who operate as a business, and it can take various forms (ex. limited or a general partnership). Partnerships file separate returns, otherwise known as Form 1065, and all incomes and losses from the business are reported on the individual tax returns of the partners.
• Limited Liability Company: An LLC is a mix between a partnership and corporation, and there are different LLCs you need to be aware of. For instance, a single-member LLC is regarded as a distinct entity when it comes to federal tax classification. This means that you do not have to use a separate tax application, and all expenses and income should be recorded on Schedule C.
• Corporations: This entity type is what many think of when it comes to business operations. A C corp is the default corporate entity, and it files Form 1120 for tax purposes. Shareholders would pay individual income taxes on the dividends they receive, and the corporation itself would pay business income taxes, otherwise known as double taxation.
When it comes to an S corp, it is a tax designation that has the same features of a partnership. An S corp uses Form 1120-S, a form which passes all losses and income from the business to shareholders. Shareholders would then record the information from Form 1120-S on their personal tax returns.
S Corp Limitations
S corps must be domestic entities in order tobe regarded as pass-through tax entities. With that, you must be aware of other restrictions:
• An S corp can only have 100 shareholders
• Shareholders must be U.S. citizens (non-U.S. citizens and non-residents cannot own S corp shares).
As is the case with pass-through members, S corp owners must adhere to the same marginal tax rates as wage earners do. With that, the amount that owners pay is based on the degree to which they participate in business operations. For instance, active shareholders participate in the everyday operations of the business, while passive shareholders take no part in business operations. Active shareholders may also take a salary while receiving dividends, allowing them to save on self-employment taxes.
Giving yourself a salary allows you to categorize your income and lower the amount of self-employment taxes you would pay since the S corp would withhold portions of your self-employment taxes. With that, you should pay yourself a reasonable salary to avoid a response from the IRS. The IRS will scrutinize artificially low salaries.
In the U.S., corporations may choose corporate taxation at the business or shareholder levels. Corporations that choose to be taxed at the business level file a corporate tax return and pay any taxes owed, otherwise known as a C corp. Also, dividends that C corps dispense to shareholders are subject to taxation and must be paid at the shareholder level.
S Corp Benefits
On the other hand, a corporation can choose shareholder taxation, and S corps provide this option. The business would still file a corporate tax return, but all income would be dividedbetween shareholders. The shareholder receives dividends based on his or her investment portion in the business and would pay taxes based on that portion. In addition, shareholders may factor in deductions and credits accordingly on their returns.
• Consider the following example: XYZ Corporation is an S corp with a sole shareholder, Mr. X. XYZ has net income of $100,000 that is taxable. The $100,000 is passed from the business to Mr. X on Schedule K-1. The shareholder would then use the form to report the income on Schedule E. Then, he would add the remaining income via Form 1040.
S corp owners would pay federal income taxes (with the top marginal rate being 39.6 percent), including local and state taxes, which range from 0 to 13.3 percent. Also, no income taxes are paid at the business level, but everything is passed through the personal tax realm. The S letter refers to the IRS subchapter code.
To learn more about S corp tax rules, submit your legal inquiry to the UpCounsel marketplace. UpCounsel’s attorneys will help you in matters pertaining to tax law and how you can use the S corp system to reduce your tax balance. In addition, they will help you with all rules and operating procedures that come along with managing a corporate entity.