S Corp Taxation: Everything You Need to Know
Understanding S corp taxation is imperative if you're comparing different business organizations3 min read
Understanding S corp taxation is imperative if you're comparing different business organizations. For corporations in the U.S., companies have the option to be taxed at the shareholder or corporate level. When the company is taxed at the corporate level, it files a corporate return. This is a traditional C corporation method of taxation.
The company can also be taxed at the shareholder level, which still requires the business to file its own return and measure its income. Income, along with tax credits and deductions, is split among shareholders. There is no income tax at the corporate level. This is S corporation taxation.
S Corporation Features
There are some basic features of an S corporation:
- An S corporation passes through its income, deductions, losses, and credits to its shareholders to pay federal income taxes.
- These are then reported on the shareholders' individual tax returns and assessed at personal income tax rates.
- This is how the "double taxation" issue is avoided. S corporations are still responsible for certain taxes on passive income and built-in gains.
S Corporation Taxation
As mentioned, S corporations are treated as pass-through entities, so there is no federal income tax. Pass-through treatment means all income and credits or deductions stay the same as they leave the S corporation and pass through to the shareholder's personal returns.
If an S corporation sells assets that fall under the long-term capital gains treatment, the income is noted on the Schedule K-1 under long-term gain. Schedule K-1s are distributed to shareholders, so that means the long-term gains also transfer to the shareholder's personal tax return.
If an S corporation donates to charity, it's also similar and goes on the Schedule K-1 so the shareholder would report it on their tax returns as an itemized charitable deduction.
How are S Corporations Taxed?
S corporations have specific criteria that must be met first, including only 100 shareholders, all of whom are US citizens, and no other businesses. Owners in S corporations may pay different taxes depending on how active they are in the company.
Passive shareholders do not participate while active shareholders are involved with day-to-day aspects. S corporation owners pay individual federal taxes, state, and local income taxes. Where the difference in taxes lies is with how payroll taxes are handled.
Active shareholders typically receive two types of income from S corporations — wage income and profit distributions. Payroll tax applies to the wage income. Profit distribution is not subjected to payroll taxes. To keep businesses from distributing all the income to avoid taxes, the IRS requires S corporations to pay a "reasonable wage" to active shareholders.
Taxes Applied at the Corporate Level
S corporations are required to pay excess net passive income and LIFO recapture tax at the corporate level. This only applies if the S corporation was once a C corporation or it went through a tax-free reorganization with a C corporation. Passive income includes items like annuities, rents, royalties, and interest income. Excessive net passive income tax applies if the passive income exceeds 25 percent of gross receipts. LIFO stands for last in, first out inventory measurement method. You have built-in gains when an S corporation gets rid of an asset in the five years of acquisition under certain conditions.
C corporations face the "double taxation" issue. When it earns taxable income, it is taxed at the corporate level. Then, when profits are distributed to shareholders, they're taxed as a dividend. This is the draw for S corporations as it avoids the corporate level taxation.
C corporations hoping to avoid the double taxation issue can't just elect to change to S corporation status. Instead, on the date it becomes an S corporation, any earnings and profits earned through the change in status date will be taxed as a dividend still.
For people who are self-employed, one way to avoid higher Medicare and Social Security taxes is to organize as an S corporation. When you're an employee, you are only responsible to pay a portion of these taxes. If you're self-employed, you have to cover both the employer and employee portions.
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