Introduction to S Corporation Taxation

An S Corporation tax is levied on businesses that elect to be structured as such. This election will determine how the company is taxed at a corporate level as well as how their shareholders are taxed.

When a corporation chooses to be structured as a C corporation, they will have to file a tax return by measuring the business' income and using corporate tax rates to determine what they owe. When a C corporation pays its shareholders through earned dividends, the shareholder will also pay taxes on the personal tax return for those earnings. This is known as double taxation.

When a business is treated as an S corporation, the taxes will only be collected at the shareholder level. While the corporation will file an annual tax return to determine the total amount of taxes that will be owed, the corporation will not be the one to pay the liability. Instead, each shareholder will be responsible for paying their portion of taxes on the income through their personal tax returns. The shareholder will also record their business deductions and credits for their portion of the business as well in their personal tax return. With this type of taxation, S corporations will not be subject to the double taxation that C corporations face.

Because there is no corporate tax levied at the corporate level, the income taxes will be paid at the shareholder's personal income tax rates. To determine the amount each shareholder will pay, you will use the IRS Form 1120S for the corporation's tax return and Schedule K and K-1s will be used with the shareholder's personal tax return.

Since an s corporation is required to be a domestic corporation, if the corporation loses money, the shareholder will often be able to account for those losses on their tax return. For example, if an S corporation owned by two people has a loss of $9,000 in a year, typically each shareholder will be able to write off $4,500 of the loss on their individual tax return, saving them a significant amount.

An S corporation is only allowed to have 100 shareholders, and they all must be United States citizens. If your business meets this restriction, structuring it as S corporation can be a great option to reduce the taxes a corporation will be required to pay. Individuals who are self-employed will need to pay federal, state, and city income tax as well as Social Security and Medicare taxes.

There are some things you will need to consider when deciding if the S corporation structure is right for your business.

  • An S corporation allows the owner of the business to be taxed on a portion of the business profit.
  • While you pay fewer taxes, the IRS may look more closely at your taxes since your overall tax liability will be reduced.
  • Your business profit will be separated into two categories: shareholder's wages and distributive share.
  • Since an S corporation operates as a pass-through tax entity, the owner may still face tax rates as individuals. This amount may vary depending on how much participation they have in the business.
  • Active shareholders will be expected to participate in the daily activities of the business.
  • An owner of an S corporation will most likely be paid a salary which will be taxed for FICA at the payroll level.

Considerations for Salary

There are many things that will be considered when determining an owner's salary. Some things that may affect the level of tax paid include:

  • The owner's duties and responsibilities.
  • Their training and experience.
  • The amount of time they devote to business affairs.
  • The wages that are paid to non-shareholder employees.
  • The dividends that stockholders receive.
  • The amount other businesses would pay for similar employment services.

In essence, shareholders of an s corporation will end up being taxed on what should be their portion of the business profits, whether they received those dividends or not. Additionally, a shareholder in an S corporation will be allowed to receive distributions that are not taxed as long as the amount does not exceed their cost basis in the S corporation.

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