Choosing a business structure requires a calculation that balances tax and legal benefits with costs and time to set up. It is one of the most critical decisions you will make when starting a small business.
Many small business owners are reluctant to choose business tax because it takes longer to get started, but don’t doubt an S Corp tax position as there are some great tax benefits that you can lose.
How does S Corps Taxes work?
Don't let the word "corporation" confuse you. S corps do not pay corporate earnings tax. In contrast, S corporations enjoy pass-through taxation in which the company owners pay taxes on their share of the company's profits based on individual tariffs.
To get an S corps tax treatment, register your corporation as an LLC or a C corporation. then, complete IRS Form 2553 to elect S corporation taxation.
However, not all C corps and LLC are eligible for S Corps tax status.
Three tax advantages of filing as an S Corporation
The S Corps status offers several advantages over other types of companies. The main advantages are the prevention of double taxation, employee shareholders' status, and limited liability.
No double taxation
C corporations, called traditional corporations, pay income tax at the entity and shareholder level. One of the trademarks of S corporations is shareholders' tax only.
Suppose a C Corps with a shareholder has a taxable income of $ 100,000.
• Entity-level tax: The entity pays income tax of 21% on net income of $79,000 ($ 100,000 of taxable income = $ 21,000 of income tax).
• Shareholder-level tax: C Corps declares the entire $79,000 in cash dividends to its 100% shareholder. Shareholder pays dividend income tax of $79,000 upon filing personal tax Form 1040.
This example shows that cash dividends, called distributions to shareholders, are essentially taxed twice. As a C corp owner, any income that goes into your bank account is taxed twice.
S Corporations and other pass-through entities eliminate taxes at the entity level, shifting all tax obligations to owners, called shareholders. If the S corporation has taxable income of $ 100,000, the entire $ 100,000 is taxed on shareholders' income tax returns.
It is important to note that the S-Corps do not always triumph in the C-Corp vs. S-Corp battle. Owners of C corporations who prefer to reinvest their business profits can essentially eliminate the second level of taxation.
Shareholder employee status
Many LLC owners, named members, elect S Corps status to be classified as employees of their organization. Unlike other pass-through entities, shareholders of the company who actively participate in management can be considered employees.
The owners of the issuing entities are generally considered self-employed, which means that they pay the employee and the employer part of the taxes provided for by the Federal Insurance Contributions Act (FICA), i.e., 15.3% of gross salary.
The owners usually pay both halves of FICA out of the total share of the transferred profits, but this is not the case for S corporation shareholder-employee.
Shareholder-employee of S Corp must receive a salary, subject to FICA taxes. When distributing additional income, shareholder-employee may receive dividends, which are not subject to FICA tax. Federal and state income taxes continue to apply to all income, but shareholder-employees can avoid 15.3% in taxes on dividends received.
For example, a shareholder-employee compensation package might include a salary of $ 50,000 plus an additional $8,000 in cash dividends. The $ 50,000 is subject to FICA, but the $8,000 is not.
The IRS pays special attention to the shareholder-employee of S corporation to avoid abuse of this classification. A reasonable salary must be paid before receiving a tax-deductible dividend.
Limited liability
S Corps have two identities. They are S corporations for tax purposes but started as a C corporation or LLC, two structures that give owners limited liability.
Unless you guarantee a business debt, your personal liability usually does not exceed your investment in the business. Of course, there are times when a business transaction "breaks the corporate veil," opening it up to greater liability.
How to file S Corps Taxes
Pass-through taxation does not mean that your business does not pay taxes. Follow these five steps to report your taxes as S Corp.
Prepare your Financial Statement
One of the first things your tax advisor will ask you about is your budget. Even if you are using tax software for your business taxes, you will need a full financial statement before you begin.
The profit and loss statement and balance sheet contain most of the information needed to complete your tax filings. It would be best if you kept your accounting software open during the process so that you can have a closer look at your expenses.
Issue Forms W-2
Before you file your professional tax return, you must complete and issue W-2 forms for all employees. The W-2 form shows the employee's salary and how much the employer withheld in FICA taxes during the year.
With the cover sheet Form W-3, the forms are sent to every employee, the Social Security Administration (SSA), and state and local governments.
The shareholders involved in the management will receive a W-2 Form as their total compensation must include a salary. The first box of Form W-2 should include all health insurance premiums that S Corp has paid on behalf of a shareholder.
The W-2 compensation, even for shareholders, is a business deduction.
Prepare the Form 1120-S Information Return.
Although companies do not pay taxes at the entity level, they still file income tax returns, known as an information return.
S corps use Form 1120-S to report income, losses, loans, and deductions. It vaguely resembles C Corps Return, Form 1120, so be sure to download the correct one.
Here you'll find one of the downsides of electing S corporation status: Form 1120-S has many built-in time limits and can get confused quickly. Keep a tax professional closer when filing your S corp tax return.
Remember that shareholders of S Corps can also be employees? Remember to deduct your W-2 salary on Form 1120-S.
W-2's profit to shareholders is shown on line seven and other employees' profit on line eight.
Distribute Schedule K-1
S Corps must complete Schedule K and Schedule K-1. Yes, they are different. Start with Schedule K, an embedded section of Form 1120-S, to summarize the income, deductions, and credits of the S corporation that will be transferred to shareholders.
The total revenues of an S Corp are broken down in Appendix K-1. S corporations provide a Schedule K-1 to shareholders, informing them of the portion of S corporation profits for which they are responsible for paying personal income taxes.
Most S corporations allocate shareholders' profits based on percentage ownership but may come to a different deal.
File Form 1040
As an S Corp shareholder, you pay income tax on two types of income: your salary and your S Corp earnings share. You will often hear about W-2 and K-1 income, respectively. Both are declared in the personal income tax return.
Your W-2 income appears on the first line of Form 1040. Then report your portion of S Corp earnings on part two of Form 1040, Schedule E, a general form for additional income, Form 1040, Schedule 1, a summary of Schedule E, and other income adjustments.
The shareholders of the organization should not act alone when filing their taxes. Get a tax preparer or tax software to walk you through the filing process.
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