S Corporations and Taxes: Everything You Need to Know

S Corporations and Taxes: Everything You Need to Know
••• Drazen_/E+/GettyImages

If you run a business, you’ll be taxed on the income you bring in each year. Whether the business is taxed or you claim the income on your own personal income taxes depends on the way you structure your business. By forming a corporation, you establish that the business is making the income, not you as an independent contractor or small-business owner. However, that doesn’t mean you won’t pass the income through to your personal income tax. An S Corporation operates similarly to a smaller business when it comes to how income tax is paid, passing the income made through to the shareholders.

S Corporation Taxes

S Corporations are known as pass-through entities, which simply means that income isn’t taxed at the corporate level. Instead, it passes through the business on its way to owners, who then pay tax on the income when they file their own taxes. That doesn’t mean that S Corporation owners don’t have to file a return on behalf of the business. S Corporations file Form 1120S, where they report all income, gains, losses, deductions and credits. But this is an informational return, designed to simply let the IRS know the business’s financial activities during the tax year.

Part of Form 1120S includes Schedule K-1, which helps you break down each partner’s share of income, deductions and credits. This avoids the double taxation that affects C Corporations, which sees income taxed at both the corporate and personal level. With a C Corporation, income is taxed on the business’s tax returns, with the profits paid to shareholders, who must then claim the money they personally received on their personal income taxes. However, there are reasons businesses might choose C Corporation status over registering as an S Corporation.

How to Structure Your Business

There are five commonly used business structures: sole proprietorships, partnerships, C Corporations, S Corporations and limited liability companies. If you kick off your business and claim income on your personal income taxes, you’ll be operating as a sole proprietorship. However, if you start a business with a partner, you’ll label yourself a partnership and split income and deductions on your personal taxes. The same goes for an LLC, which the IRS treats as a sole proprietorship if it’s a one-person operation or partnership if it has more than one owner.

Once you’ve registered as a corporation, though, tax filings change. One of the biggest reasons business owners choose to go this route is that it separates the business from their personal assets, but that protection is also provided to an LLC. It simply means that if your business becomes the subject of a lawsuit, your personal assets won’t be taken to settle any judgment against you. Since it separates your business and personal finances, it also protects your personal assets if your business must someday file bankruptcy. However, there are instances where creditors can still come after your personal assets, particularly if your behavior leads the courts to rule that you “pierced the corporate veil.” If you’re operating legally and honestly, though, you’ll likely find protection by setting your business up as an LLC or corporation.

S Corp Versus LLC

If you’re a more casual, laid-back person, an LLC might be the best option for your business. Unlike S Corporations, which are limited to 100 shareholders, LLCs can have an unlimited number. You also won’t be able to have shareholders who aren’t residents of the U.S. as an S Corporation. Management is also structured differently between LLCs and S Corporations. LLCs can have owners or members managing it, while S Corporations have directors who make major decisions and officers who manage day-to-day business affairs.

In general, you’ll find that S Corporations simply have more formalities than LLCs. With an S Corporation, you’ll need to adopt bylaws, hold annual shareholder meetings and keep records of your meeting minutes. There’s a higher level of accountability with an S Corporation, whereas an LLC can have formalities but isn’t required to. Experts recommend still having documentation like operating agreements, holding annual meetings and keeping documents of them and documenting all major decisions.

S Corp Versus C Corp

Outside of the tax benefits, S Corporations and C Corporations have so many things in common that it may be difficult to decide between the two. The C Corporation tends to be the standard for businesses as they grow, but S Corporations are given special tax status. The biggest difference between the two is the way they’re taxed, with C Corporations seeing a separation between the owners and the business itself when it comes to taxes. C Corporation shareholders have to pay taxes on the income the business earns, then again on the money they take from the business and put in their own personal bank accounts, known as dividends. If owners take a salary, that is taxed as personal income as well. S Corporations skip the step where the business is taxed and tax it under each owner.

One of the biggest benefits of a C Corporation is that owners don’t pay self-employment tax on the income the business earns. If they take a salary, they aren’t self-employed. For shareholders receiving dividends, those don’t count as self-employment income either. Since self-employment tax is 15.3 percent, it can mean substantial savings for some business owners. For C Corporations, business income is not treated as personal income, so there’s no need for Social Security and Medicare taxes to be withheld from it until the money transfers to the shareholders and owners.

Becoming an S Corporation

Forming an S Corporation involves several steps, starting with filing papers with the appropriate state agency. This is where you’ll need to specify whether you’re a nonprofit or for-profit corporation and provide the documentation necessary to establish your business as a corporation with the state. You’ll also need to apply for an Employer Identification Number if you don’t already have one. This can be done through the IRS website in a matter of minutes.

Once you’ve established your business locally, it’s time to alert the IRS to your desired status. For the special tax considerations that come from running an S Corp, you’ll need to file Form 2553 with the IRS and get approval. Within 60 days, you should get a letter from the IRS confirming or denying your request. If you’re approved, you’ll be officially operating as an S Corporation and you can file an S Corporation tax return when tax time rolls around.

S Corporations and Estimated Tax

If you operate as an S Corporation, you aren’t having taxes taken out of your earnings and submitted to the IRS with every paycheck, as an employee would. This means on April 15, you’ll have to pay the full amount of taxes due on your earnings for the year, along with interest and penalties for underpayment. If you think you’ll owe more than $1,000 in taxes at the end of the year, the IRS expects you to pay quarterly, sending 25 percent of your total tax for the year in mid-April, mid-June, mid-September and mid-January.

For many S Corp owners, though, predicting the exact amount of income for the year can be dicey. For that, the IRS provides Work Sheet 2-1.2018, which is an estimated tax worksheet included as part of Publication 505. You’ll still be guessing, but it will help you figure how much you can expect to owe in taxes after deductions, the alternative minimum tax, credits and other items are factored in. Once you have a total, the IRS directs you to divide the amount by four and submit each of those four payments by the due date.

Corporate Tax Rates

One bonus to being a C Corporation after the Tax Cuts and Jobs Act is the tax rate. The corporate rate has dropped from 35 percent to only 21 percent, which means a business will only pay 21 percent in tax on the income it generates each year. However, it’s important to note that C Corporations also must pay corporate income taxes at the state level in 44 states, so the total tax liability may be higher than if you claimed it on your personal income taxes.

Figuring the S Corporation tax rate can be complicated since income is taxed at your personal income tax rate. These tax brackets have changed with the new tax laws, as well, so it’s important to do some calculations to determine which is the better option for you. This is especially true since C Corporations face double taxation. In other words, even though you’re paying 21 percent in corporate tax, you’ll also face taxes on any income you personally earn from the business.

Taking Money Out of an S Corporation

It can be a misconception that S Corporations don’t have distributions like C Corporations do. The money can still be distributed to shareholders, it’s just taxed differently with an S Corporation. It’s known as a nondividend distribution and it is not taxed unless the amount of the distribution exceeds the shareholder’s stock basis.

If you do make nondividend distributions to shareholders, you’ll need to issue a Form 1099-DIV at tax time and the shareholder will use the information to file their taxes. If the amount issued falls beneath the shareholder’s stock basis, no tax should be due. If no form is received, however, the shareholder should report the distribution as an ordinary dividend. Once the shareholder’s basis has been reduced to zero, the shareholder will then report any distributions on Schedule D as a capital gain.

Loans, Wages and Reimbursed Expenses

In some cases, shareholders in an S Corporation may also work as employees of the business. When that happens, wages for work performed are issued in the form of a paycheck, as with every other worker on the payroll. For those shareholders, taxes will be taken out and submitted to the IRS, eliminating the need for that shareholder to pay self-employment tax on the money owed. However, the IRS requires that shareholders receive reasonable compensation for their work, so disguising a shareholder as an employee for tax purposes will likely be penalized if it’s discovered.

Business owners and shareholders may also occasionally request to take a loan on the business’s income for whatever purposes. As far as the IRS is concerned, this isn’t prohibited, but you’ll need to prepare a promissory note documenting the loan and the terms of repayment. You’ll need to attach a fair market interest rate to the loan, as well as a deadline for the final payment.

One area of confusion, though, is expenses. With a C Corporation, the business is responsible for repaying qualifying expenses reported by employees. If you’re self-employed, generally you pay expenses out of the money you’re making from the business, then deduct them at tax time. With S Corporations falling between those two extremes, it can be difficult to ascertain exactly who is ultimately responsible for paying expenses. If owners, shareholders or employees accrue expenses, you’ll need to make sure you have documentation in place to prove the expense before taking the reimbursement for it.