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S Corporation Basics

The S Corporation is said to be the most common entity type in the United States. But there is a lot of confusion about what an S Corporation really is, including the notion (perpetrated by the previously stated fact) that the S Corporation is an “entity type”. An S Corporation is not really a type of entity, but rather a tax election which may be made by various legal entities.

Corporations are animals of state law. Under state law, there is no difference between a “C Corporation” and an “S Corporation”; the entities are identical under the applicable substantive laws. Additionally, a Limited Liability Company (“LLC”) can elect S Corporation status, despite being a very different legal entity than a corporation, governed by different state laws. The S Corporation status does not change the laws which govern these businesses. The election merely changes the way these entities pay and report federal income taxes.

So, what is the difference between an S Corporation and a C Corporation? The simple answer is that the S Corporation pays no federal income taxes. Of course, the “simple answer”, as often is the case, is overly simple and skews the reality of how an S Corporation works. While an S Corporation pays no federal income taxes, it is a form of “pass-through entity”, similar in some respects to an old-fashion partnership. Being a pass-through entity means that the corporation does not pay income taxes but the owners of the S corporation pay income taxes on their proportionate share of company income. For example, if Shareholder A owns 40% of the stock in S Corporation X, and S Corporation X has $100,000 of taxable income, Shareholder A will pay income tax on $40,000 of the income generated by S Corporation X ($100,000 x 40% = $40,000). The rules are a bit more complicated than what this example implies, with rules about which items of income or deductions must be separately reported to shareholders (interest income, for example is separate from operating income, and is reported separately to the S Corporation shareholders) but the example explains the basic concept of how an S corporation works.

So, either the corporation pays the tax or the shareholder pays the tax, so why would anyone want to be an S corporation? What’s the difference? The main reason behind electing pass-through tax treatment is to avoid double taxation when corporate profits are eventually distributed to the shareholders of the business. To illustrate the problem of double taxation, assume that both the corporation and the shareholders pay tax at the top corporate and individual income tax rate of 35% (ignoring progressive tax rates for simplicity) and that dividends are taxed at a 15% rate. If the corporation is a C corporation, has $100,000 of taxable income and distributes all $100,000 to its shareholders, there is a total federal tax liability of $50,000 (corporate tax of $100,000 x 35% = $35,000 plus individual tax on dividends of $100,000 x 15% = $15,000, for a total of $50,000). If the corporation were an S corporation, there would be no entity level federal income tax and only $35,000 of individual income tax liability. The individual shareholders pay 35% tax on the $100,000 of pass-through income and pay no tax on the S corporation distributions (there is no tax on dividends if they are paid from previously taxed S corporation income). The choice to be an S corporation in this example saves $15,000 of taxes…and the saving are even larger in most years, when dividends are not given a favorable 15% federal tax rate.

Some business owners get the “bright” idea of eliminating C corporation double taxation by removing the entity level tax with higher wages paid to the owners (basically paying wages, which are tax deductible, in lieu of dividends, which are not). There are two problems with this strategy: (1) the IRS is onto the ploy and will reclassify “excessive compensation” to owners as dividends and assess tax underpayments, penalties and interest; (2) the owners may end up paying much more in payroll taxes on the excessive compensation than if they had just made the election to be taxed as an S corporation. The payroll tax issue is also important in determining whether the entity should be taxed as an S corporation or a partnership (as most LLC’s are taxed). That analysis is beyond the scope of this blog entry but will be addressed in a later article.

Understanding the concept of double taxation, it seems that no corporation would ever choose to be taxed as a C corporation. But, as with most things tax, there are various complexities which could cause the C corporation to be a better tax structure. More importantly, not all corporations qualify as S corporations. There are a variety of rules regarding S corporations, including:

  • All shareholders must be individuals or certain types of trusts.
  • No shareholders can be non-resident aliens.
  • There can be no more than 100 shareholders.
  • There can be only one class of corporate stock, with identical rights as to income allocation, distributions and liquidation.

The decision of which tax entity classification is best for your business can be overwhelming. The attorneys at Penzien & McBride, in conjunction with your CPA, can help guide you through this decision as well as other decisions relating to the governance of your start-up, or established, Michigan business.