Subchapter S Corporation Taxation: Everything You Need to Know
Subchapter S corporation taxation refers to the tax treatment that corporations eligible for the election of a subchapter S can receive.3 min read
The S corporation is the fastest-growing of the different pass-through businesses. An S corporation is a domestic corporation that is viewed as a company that is pass-through. This means that the income of the corporation is allocated to the managers. The owners then must pay taxes for the income when they file their personal tax return. Just like the owners of other businesses that are pass-through, the managers of S-corporations face tax rates that are marginal as do individual wage earners.
How much managers of an S-corp pay when it comes to taxes depends largely on the role they play in a business. A passive shareholder doesn't participate in the daily operations of an S-corporation. On the other hand, an active shareholder does.
Every manager of an S-corp is responsible for paying federal income taxes on the individual level. As of 2015, the top marginal rate was 39.6 percent. Managers have the responsibility to pay local and state income taxes, which range from 0 to 13.3 percent as of 2015. These managers are also impacted by a Pease limitation when it comes to itemized deductions, tacking 1.18 percent more on the marginal tax rate as of 2015.
The distinction in how much tax every manager type is subjected to depends on how the Net Investment Income Tax of the ACA and the payroll tax impact them. The payroll tax refers to the tax that is responsible for funding Medicare and Social Security.
Shareholders who are active typically receive two forms of income from the S-corp: a profit distribution and a wage income.
The payroll tax is applicable to the wage income, as of 2015. The payroll tax is as follows:
- 15.3 percent for the first $117,000.
- 2.9 percent for an additional $83,000.
- 3.8 percent for any income that exceeds $200,000.
The payroll tax is not applicable to the profit distribution.
If an owner gets $200,000 in total income and 50 percent of the $200,000 is wage income, then he will have to pay 15.3 percent of the $100,000 in wage income, which is $15,300. The rest of the income will not be subject to the tax.
Considering that there is a huge incentive to allocate more profit and pay very little wage, the IRS has established a few businesses guidelines to follow. Top tax rates (marginal) for shareholders who are active depend on if the last dollar is wage or profit. On the other hand, passive shareholders don't have to pay a payroll tax for income because they don't earn a wage through the business. Rather, passive shareholders are subject to the Net Investment Income Tax of the ACA, which is 3.8 percent as of 2015. This tax only comes into play when income is over $200,000 or over $250,000 for those filing jointly. Due to this, passive shareholders tend to pay higher top tax rates (marginal) than shareholders who are active.
For most small business owners, S corporations are more attractive than standard corporations, which are also referred to as C corporations. This is because S corporations have excellent tax benefits while still offering business owners the liability protection that is characteristic of a corporation.
If a corporation decides to pay its taxes at the corporate level, the corporation will file a corporate tax return, measure the taxable income, and use the corporate tax rates to calculate its tax. A corporation that receives this treatment is a C corporation. When C corporations allocate profits, in the form of dividends, to the shareholders, the dividends become taxable income for the shareholder.
Corporations also have the option of choosing to pay any taxes at the shareholder level. If a corporation chooses this option, it will still need to file its own corporate tax return and measure the taxable income.
The taxable income, however, is allocated among the shareholders. Tax credits and some deductions are also divided among the shareholders. Every shareholder will include their portion of the income, credits, and deductions as part of their personal tax return.
A income tax does not apply at the corporate level. Rather, personal income tax rates (pass-through) are used to tax all items of income. A corporation that receives this treatment is an S corporation.
If you need help with subchapter S corporation taxation, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.