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S-Corporation |
Sub-chapter S of the Internal Revenue Code allows a corporation to be treated like an LLC. There are several advantages and disadvantages to electing to become an S-Corp. Unless an S-Corp election is made when a business incorporates a cooperation is automatically a "regular" corporation or C-Corp.
S-Corps are commonly used by small business proprietors because the S Corporation pays no corporate taxes. Instead it passes profits and losses directly to its owners (the stockholders) who declare such profits and losses as part of their personal taxable income. For tax purposes, S Corps are similar to LLCs and partnerships, although some subtle differences in taxation do exist. Therefore, S-Corps do not become subject to the "double-taxation" that C Corporations enjoy.
In order to elect treatment as an S-Corp, there are certain eligibility requirements which much be met. The ownership of an S-Corp is restricted to no more than 75 shareholders with only one class of stock. S-Corps cannot be owned by C-Corporations, other S-Corporations, many trusts, LLCs or partnerships. Finally, an S-Corp can not have non-U.S. citizens as shareholders.
Advantages of S-Corp Election
Income Taxes
There are three primary tax advantages derived from the fact that an S-Corp is throated as "pass-through" entity...meaning income or loss, deductions, and credits are passed through directly to a corporation's shareholders on a pro-rata basis according to their ownership percentages. The primary benefit is the ability to avoid double taxation imposed on corporate profits at the corporate level and tax imposed at the individual shareholders as dividends. A simple example using an estimated combined Federal and state corporate rate of 40% and an individual rate of 38% is shown in the table below.
| C-Corp | S-Corp | |
|---|---|---|
| Pre-tax-income | $1,000,000 | $1,000,000 |
| Corporate taxes at 40% | 400,000 | None |
| Corporate net income distributed | 600,000 | 1,000,000 |
| Individual taxes at 36% | 216,000 | 360,000 |
| Net funds available | 384,000 | 640,000 |
| Actual Income Tax Rate | 61.6% | 36% |
While somewhat oversimplified, the table data shows the substantial tax savings possible.
Two other benefits of S-Corp status is the differences between corporate and individual income tax rates. Currently, the top Federal individual rate is 31% and the election of S-Corp. status for profitable companies can mean an immediate tax savings in may cases. In addition, the pass-through of corporate income or loss directly to the corporation's owners provides each shareholder with a wide range of planning opportunities for minimizing the tax bite on corporate earnings.
Personal Liability
The election of S-Corp. treatment does not change the legal structure or standing of the corporation; it is merely a tax option. Therefore personal assets of shareholders are not at risk. Although if the lending institution requires an officer of the S-Corp to sign a personal note to get a business loan, then that protection is forfeited for the amount of that specific loan. Always consult your attorney before signing any contracts as an S-Corp officer.
Disadvantages to Electing S-Corp Status
Normally an S-Corp. must use a calendar year in filing its tax returns.
This may present a dilemma for government contractors who have historically chosen to use a fiscal year end, such as September 30 as well as loss of the ability to recover state taxes as part of a company's indirect cost. The adoption of S-Corp. status transfers responsibility for such state taxes to the individual shareholders. It also complicates multistage tax filing.
Final Word
I've briefly described the advantages and disadvantages of S-Corp status. All of the rules and regulations governing subchapter S-Corps, as well as recent decisions and current issues presently before the various courts today, would require a discussion of S-Corp beyond the scope of this article. The information contained in this article is presented to provide a general understanding of the benefits and cautions in electing S-Corp status.
For more detailed information and specific advice for your business contact your local small business development center, your accountant or your attorney