Here’s Something to Think About
To answer this question, we should first ask, “What is an S corporation?”
An S corporation is a company, that is organized as a corporation or limited liability company (LLC), and elects S corporation status with the IRS by filing form 2553.
What makes an S corporation special? There are three other ways for you to organize your company for income tax purposes: sole proprietorship, partnership, or C corporation. Let’s compare S corporations with each of these types of tax structures. Let’s start with the sole proprietorship.
First, a sole proprietorship has only one owner. An S corporation may have up to 100 owners, called shareholders.
Second, both the sole proprietorship and the S corporation pass taxable income through to the owner or owners. However, the sole proprietorship reports income and expenses directly on the owner’s personal tax return. The S corporation files a separate tax return and provides each shareholder with a K-1 form for the owners to use in reporting the income on their personal tax returns.
Third, the shareholders of an S corporation are also employees if they work for the company. In other words, they are required to take a fair salary for their efforts and receive a W-2 form from the company at year end. Sole proprietors are not allowed to take a W-2 eligible salary. They distribute profits directly to themselves.
Finally, owners of sole proprietorships pay self-employment tax (Social Security and Medicare) on all taxable profit. Shareholders of S corporations only pay Social Security and Medicare on their salaries. Any profit above salaries escapes Social Security and Medicare taxes.
Let’s compare S corporations with partnerships.
First, a partnership must have more than one owner. An S corporation may have one or more owners.
Second, both partnerships and S corporations file separate tax returns and pass through taxable income to the owners by way of the K-1 form mentioned above.
However, partners in a partnership do not take a salary from the company. If they work for the company, they receive guaranteed partner payments for their services. A guaranteed partner payment does not result in the issuance of a W-2 and has no taxes withheld. As mentioned earlier, S corporation shareholders receive W-2 salaries.
Third, both profit and guaranteed partner payments for partners are subject to self-employment tax, just the way sole proprietors are subject to self-employment tax on all profits. S corporation owners only pay Social Security taxes on their salaries.
Let’s compare S corporations with C corporations.
Both file tax returns separately from owners. However, as mentioned above, S corporation owners receive a form K-1 for profits and pay taxes on those profits on their personal tax returns. A C corporation pays its own taxes on its corporate tax return.
In addition, the owners of a C corporation pay personal taxes on any dividends that they receive from the company. There are two levels of taxation on a C corporation.
We have not addressed the best entity type for your business. That is dependent on a lot of factors, and at S&K we provide business owners with advice in this complex area.
We have also not discussed which tax structures tend to lead to the lowest total taxes. I will tackle this in my next blog post.
If you have any questions, please contact me at fstitely@skcpas.com or call (703) 818-8284.
Thanks for reading!
Frank Stitely, CPA, CVA