1. C Corporation Taxation
2. S Corporation Taxation
3. Reasonable Salaries
4. Advantages of S Corporations
5. Potential Disadvantages of S Corporations

Within the S corp tax structure, a corporation is treated as a pass-through entity for tax purposes. S corporations issue stock and function like traditional C corporations. Owners also benefit from the same liability protections as C corporation shareholders.

C Corporation Taxation

In the United States, corporations can choose to be taxed at the corporate or shareholder level. A corporation that opts to be taxed at the corporate level is a C corporation. A C corporation pays a corporate tax on net income and, when it distributes dividends, its shareholders are taxed at the shareholder level, as well.

S Corporation Taxation

A corporation can choose to instead only be taxed at the shareholder level. The corporation still files its own return, although it's mostly informational in nature. Taxable income plus deductions and credits are then divided among shareholders. Each shareholder is required to include this amount on his or her personal tax return. The company typically pays no income taxes at the corporate level. This is called S corporation status, and the letter S is in reference to Internal Revenue Code Subchapter S.

S corporations use IRS Form 1120S to file their annual returns. Schedules K and K-1 show how income and deductions are allocated between shareholders. The S corporation doesn't pay federal income tax and instead passes it along to the shareholders, who are taxed on their income share.

Shareholders are not required to pay self-employment tax on their share of the profits, but before profits are distributed, owners who are also employees must receive a "reasonable salary." It's important to note that the share of business income is taxed regardless of whether it was distributed to shareholders.

S corporations must pay some taxes at the corporate level:

  • Excessive net passive income
  • Built-in gains tax
  • LIFO recapture tax

Passive income includes things like interest income, dividends, rents, royalties, and annuities. An excess net passive income tax applies if passive income is more than 25 percent of the gross receipts.

Reasonable Salaries

One of the major benefits of S corporations is that shareholders aren't required to pay self-employment taxes on their share of the profits. There is a catch, however, in that before profits are calculated, any owner who works as an employee must be paid a "reasonable salary."

This salary amount will be subject to Medicare and Social Security taxes, half of which the corporation pays and half the employee pays. Savings from not having to pay self-employment taxes don't take effect until the company is earning enough money to have profits after paying out reasonable salaries.

Reasonable salaries are frequent topics in court cases where the IRS believes business owners are paying small salaries to avoid self-employment taxes. The IRS tax code doesn't define or provide specific details on what constitutes a reasonable salary.

If a case goes to court, the IRS often looks at a variety of issues prior to ruling on the matter:

  • Responsibilities and duties of the shareholder (employee)
  • Experience and training
  • How much time is devoted to the business
  • How much in dividends were paid to shareholders
  • Wages of employees who aren't shareholders
  • What similar businesses pay for comparable services

Advantages of S Corporations

  • You can transfer ownership interests without negative tax consequences.
  • S corporations are not forced to use the accrual method of accounting like C corporations are.
  • S corporations often have better credibility with clients, customers, vendors, employees, and partners because of the formal commitment required to incorporate.

Potential Disadvantages of S Corporations

  • Ongoing fees are higher than what a sole proprietor or partnership would incur.
  • S corporations must adopt a calendar year for tax purposes unless the company can establish a business purpose for using a fiscal year.
  • Because an S corporation can only have one class of stock, there are no investor classes where shareholders are entitled to different distribution rights or dividends.
  • There's a cap of 100 shareholders.
  • Foreigners and certain types of trusts and other entities cannot be shareholders.
  • Because S corporations can only issue one type of stock, they cannot allocate income to specific shareholders easily.
  • For shareholders with more than 2 percent ownership, many fringe benefits (medical insurance, life insurance, etc.) provided by the S corporation are taxable.

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