S Corporation Taxation 101
An “S” corporation is a corporation, just like a C corporation. Its shareholders enjoy the same general shield from personal liability for the corporations’ acts or omissions. The main differences lay in the tax structure of both entities and with certain restrictions on ownership. S corporation taxation presents a unique set of advantages for the shareholders. But, most new startups have some common questions about how the corporation and the individual owners will be taxes. Here are 7 common questions and the answers to help you determine if organizing or re-organizing into an s-corporation is right for your business.
1. Is the S Corporation entity taxed?
In terms of tax treatment of the S-Corporation, there is no federal corporate income tax on S corporations. Some states impose taxes on income on S corporation profits (i.e. “replacement taxes”) and this can vary from state to state. S corporation status is achieved by electing such tax treatment after organization (IRS Form 2553). Net profit or loss after expenses for S corporations, including salaries paid to employees and shareholder-employees, is reported on federal Form 1120S and this income (or loss) is “passed through” to shareholders’ personal tax returns via Schedule K-1. (Additionally, pass-through losses are limited to the taxpayer’s basis in the stock of the S corporation). Distributions of profits from the S corporation are subject only to the shareholder’s ordinary income tax rate (or even capital gains depending on the individual shareholder’s basis) and avoid self-employment taxes.
2. Do s-corporation shareholders pay self-employment taxes?
However, all wages are subject to payroll taxes. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The S corporation will pay the employer’s share of FICA taxes (7.65%), and the employee will pay the other share of FICA taxes (also 7.65%). Between the S corporation and the shareholder, wages are subject to approximately a combined 15.3% payroll tax, plus the shareholder’s income tax rate. So all things considered, the shareholder-employee should pay as little salary to themselves as is permitted in order to decrease the amount of taxes paid on corporations’ profit stream.
But, IRS rules do require that reasonable salaries must be paid to shareholder-employees (the failure to do so is considered by many to trigger an internal audit). All other earnings avoid self-employment taxes. This means that payroll taxes would have to be paid on reasonable salaries (wages) of employee-shareholders only, and not the S corporation’s distributions to any of its shareholders.
3. When do shareholder/employees need to pay wages to themselves?
According to the IRS, reasonable compensation is determined by what the shareholder-employee did for the S corporation. The IRS will look at the source of the S corporation’s gross receipts: 1) services of shareholder, 2) services of non-shareholder employees, or 3) capital and equipment. If the gross receipts and profits come from items 2 and 3, then no compensation needs to be paid to the shareholder-employee. However, if most of the gross receipts and profits are associated with the shareholders personal services, then most of the profit distribution should be allocated as compensation. (Of course, you should ask an accountant for more details).
Even if income is not distributed to the shareholders and left as operating capital, it will still be taxable to the individual shareholders. This is because all income is passed through to the shareholders automatically. Shareholders in a C corporation are only liable for taxes on dividends they actually receive (but, undistributed income of the corporation is not subject to self-employment taxes).
4. How low can shareholder/employees set their salaries?
Obviously, the tax savings from an S corporation come from being able to set salaries for shareholder employees to some reasonable figure which is lower then the overall profits of the S corporation. The big question is how low can you go? Unfortunately, you will not get any hard numbers or a hard floor which you shouldn’t go below. Accountants can provide you with several useful tips to help you determine how you set a reasonably low salary for all shareholder-employees. Below are several general tips helpful to s-corporation shareholder/owners (which should not be substituted for professional tax advice).
-Salary Tip #1
Set a reasonable salary for yourself and for all other shareholder-employees! In the past, thousands of S corporation shareholders seem to have gotten away with paying themselves no salary! This may still hold true, but its simply not a good idea. The IRS has recently announced that it will give much more scrutiny to S corporation shareholder-employee wages go forward. The party may be over. With the hiring of thousands of more IRS agents due to Obamacare, the IRS likely will have the resources to make good on that promise.
-Salary Tip #2
Review the average compensation paid by S corporations to shareholder-employees. The IRS provides this salary statistic at its www.irs.gov website.
-Salary Tip #3
Review government databases of pertinent salary information. The Bureau of Labor Statistics web site at www.bls.gov gives average salary data for most job positions. Sometimes, the reported salaries seem low. However, its hard to imagine the IRS prevailing on an argument that the number you have used from the Bureau of Labor Statistics is unreasonably low.
-Salary Tip #4
Are there any local safe harbor salaries for your S corporation? Talk to your accountant who may tell you that the IRS has an unofficial safe harbor amount. If such a safe harbor exists, you should pay shareholder-employees at least this amount.
-Salary Tip #5
Again, grab a good accountant! First, your accountant will be able to determine if your able to lower your salary. For example, an employee provided pension plan contribution paid by your S corporation would effectively lower the salary paid to the shareholder-employee. Your accountant will also prepare and sign your tax return. That can take some heat off of you and shift responsibility over to your accountant. (Of course, that is why he or she will likely make sure your setting the proper salary amounts in the first place before agreeing to prepare your return).
5. Does the s-corporation file a separate tax return?
Yes, the corporation has to file a separate federal (1020S) and state tax return, unlike for single-member LLC’s, even when there is only one shareholder.
6. Are s-corporation shareholder/employees subject to unemployment taxes?
Corporate shareholders are responsible to register and pay unemployment contributions in most states as officer/owners are considered to be employees. In Illinois, at least, LLC’s are not liable for such contributions.
7. Are s-corporations subject to separate state business income taxes?
Most states (47) charge corporate income taxes for income derived in that state, or “source income.” Businesses organized in states outside states the business conducts business in will be subject to income tax only on income earned in that state(s) or apportioned to the state(s). Your business may be liable for corporate income taxes by organizing or registering to do business in a foreign state. Illinois imposes a 1.5% personal property replacement income tax on all S corporation business income derived in the state. Most states impose a flat corporate tax rate on all business income earned in that state.
A handful of states do not impose income taxes, posing a factor to keep in mind if you ever decide to organize or re-organize away from your “home” state. States such as Nevada do not impose any corporate or LLC income tax on income derived in the state. These are the states that have been hyped by Internet incorporation services as jurisdictions where you should organize your corporation or LLC. Of course, this may not matter if your business derives income in multiple states and has enough of a presence in those states to be liable for income taxes. Any alleged tax advantages reaped by organizing the business in a state without a corporate income tax would be offset by any required income taxes in the state the business is physically located in or where the owners reside. So, simply organizing away from your home state to avoid corporate (or LLC) income taxes may not prevent your business from having to pay them at some point. This may hold especially true for Internet based businesses.
What Are LLC Franchise Taxes?
A franchise tax is a tax levied by a state for the privilege of either incorporating or qualifying to do business in that state. A franchise tax may be based upon income, assets, outstanding shares, or a combination. Some states, such as Illinois, base their corporate franchise taxes on the paid-in capital of the corporation. Other states may impose a franchise tax and corporate income tax. Some states impose a significant franchise tax while other states, such as Nevada have no franchise tax. Typically states that impose higher corporate income taxes usually have low franchise taxes. The amount of the franchise tax and the method of calculation can usually be found on the secretary of state, or similar department, website of each state. If you incorporate in a state that bases it franchise taxes on paid-in capital (such as corporations in Illinois and other states), the higher this amount is, the higher the franchise tax. Paid in capital refers to the capital contributed to a corporation by the owners through purchase of stock from the corporation. It refers to capital stock (shares issued), as well as additional paid-in capital.
Remember, incorporating without getting the advice of your accountant is a bad idea. I routinely advise my clients to talk to their accountant in conjunction with their organization to add the tax input.