S Corp Taxes for Dummies: Everything You Need to Know
Most people need s corp taxes for dummies as S corporations are one of the most misunderstood business organization types. 4 min read
Most people need s corp taxes for dummies as S corporations are one of the most misunderstood business organization types. It's likely because it's more of a tax designation rather than its own form of entity.
What is an S Corporation?
Both LLCs and corporations can opt to become S corporations; however, no state offers entrepreneurs the opportunity to become an S corporation. S corporations have the ability to avoid double taxation since an S corporation is a pass-through entity. Profits are passed on to shareholders, who report them as personal income versus the corporation paying taxes on them.
To be eligible for S corporation status, you must meet certain criteria:
- They must be domestic companies
- Shareholders can only be individual people, estates, and certain trusts only
- Shareholders cannot be non-US residents, partnerships, or corporations
- S corps must have less than 100 shareholders or LLC members
- Certain types of corporations don't qualify, including some financial institutions, domestic international sales corporations, and insurance companies
Becoming an S Corporation
S corporations can only be formed when regular corporations file a special small-business tax status with the IRS, which is done by filing IRS Form 2553 within a few months of forming the corporation.
When deciding on what type of corporation to form, companies should ask themselves what is the best method to reduce the tax burden on the business. Should you become an S corporation, provided you qualify and pass the taxable income along to the shareholders? Or, keep the business as a traditional corporation and have shareholders pay tax on the dividends in addition to the taxes the business already paid?
Corporations and Taxation
To understand the benefits of S corporation status, it's best to start by understanding how a traditional C corporation is taxed. By default, a corporation is taxed as a C corporation. Net profits are taxed at the corporate level and whatever is left can be distributed to shareholders as dividends. Shareholders pay personal income taxes on dividends.
This means the net profits are essentially taxed twice, once as a corporation and one at the personal shareholder level. The S corporation gets rid of that double taxation.
Three things to note with paying taxes based on dividends from an S corporation:
- Income or loss from the company gets reported on your 1040 tax form.
- Income is subject to federal and state taxes; however, it is not subject to payroll or self-employment taxes.
- Shareholders are taxed whether or not the S corporation paid out any income.
When S corporations pay dividends to stockholders, it can provide them with money to pay the taxes on their personal tax returns. When talking about dividends, the benefit with S corps is that you don't pay Medicare or Social Security taxes on them, which can save 15.3 percent. However, S corporation owners are required to pay themselves a "reasonable salary" which means you can't call all profits dividends to avoid any taxes. Because of the 15.3 percent tax on dividends, some companies opt to wait until they generate more income to make the change to S corporation worthwhile.
Built-in Gain Tax
There is one caveat to note with S corporations where shareholders can have a greater tax liability in a particular situation. It rests on the concept of "basis," which is the amount personally invested in your S corporation stock. If an S corporation makes distributions that exceed a shareholder's basis, the amount above and beyond is considered a capital gain. In some instances, corporations become S corporations right from the start. For companies who were C corporations previously, several rules apply.
The "built-in gain tax" is important to know for companies that convert from C to S corporations. If an S corporation sells an asset that appreciated, and the period of appreciation was from the time it was a regular corporation, the built-in gain is taxed at the highest corporate rate. This prevents C corporations from trying to avoid income tax by selling off assets and then converting to S corporation status. C corporations that are contemplating becoming an S corporation will want to retain a competent tax professional to help analyze the pros and cons.
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