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S Election Benefits

 

Subchapter S Corporation Election (Section 1361)

Do you run a small business? Do you want to start a business, but are unsure of the right tax structure? There are many forms your business can take. These options include:

• Sole Proprietorship (disregarded entity)
• Partnership
• Subchapter S Corporation (S-Corp)
• C-Corporation

Getting your business in the most beneficial tax structure is incredibly important for the future of your business and your taxes. Here we will be discussing the advantages and disadvantages of the Subchapter S Corporation (S-Corp) and the rules surrounding it.

What is it?

               An S-Corp is a type of business structure with unique advantages. In 1958 your options to start a business were limited. Limited Liability Companies did not get their start till 1977, so if you wanted to go into business by yourself, you assumed a large amount of risk. If you wanted a business with your friends or colleagues you were limited to a partnership or C-Corporation. President Eisenhower and Congress wanted to spur small business creation, and so the Subchapter S Corporation was born.

To begin, we should review some common elements people hear when creating their business. A limited liability company (LLC) is a type of business structure that provides the owners, called members, protection from the debts and liabilities of the business. An LLC can take any of the four business forms listed above. This means you could be a sole proprietor LLC, partnership LLC, etc. The rules surrounding forming an LLC vary by state. Typically, they involve filing Articles of Organization with the Secretary of State in the state you wish to create your business.

Sole Proprietorship is one of the simplest ways to start a business. The income and expenses are reported on Schedule C of Form 1040 on your personal income tax return. The profit made from running your business is subject to federal income tax as well as self-employment taxes. Self-Employment taxes consist of the Social Security and Medicare payments. The tax percentage equals 12.4% for Social Security and 2.9% for Medicare. These are sometimes referred to as payroll taxes. When you work for someone earning a W-2 wage, the employer pays half and you pay half. However, when you are working for yourself as a sole-proprietor or in a partnership you are expected to pay both halves of the self-employment tax. Therefore, you are subject to both your marginal income tax rate as well as 15.3% in self-employment taxes.

Partnerships are businesses formed by 2 or more persons. The partnership is not taxed directly on the earnings. Instead, the partnership files a form 1065 and generates forms K-1. These are sent to each partner and reports their share of the income/deductions. Each taxpayer then reports this information on schedule E of their individual tax return and pays the appropriate federal income tax as well as self-employment taxes. This form of reporting income/deductions for taxes is called pass-through taxation. Normally the income/expenses are allocated to each partner based on their ownership interests, however partnerships can make special allocations that are different from the ownership percentages. There are specific rules surrounding this so it is best to consult your tax professional on whether this is right for you.

C-Corporations are a form of business many people are familiar with. The business is created by filing articles of incorporation. Shares are issued to investors in the company. The shareholders have voting rights and elect a board or directors that guide the company. C-Corporations are considered distinct and separate entities from their shareholders. The corporation pays taxes on its earnings at the corporate income tax rate which is currently 21%. If the business wants to return money to shareholders it can do so through dividends. These dividends are taxed again as income to the shareholders. Effectively, the income is taxed twice. This double taxation is the main downside to C-Corporations. Further, C-Corporations have more administrative requirements than sole proprietorships and even partnerships depending on the operating agreement. Therefore, a C-Corporation may not be the right structure for all businesses.

S-Corporations were created to help small businesses. S-Corporations are formed by filing Articles of Organization or Articles of Incorporation. After this, the business will file form 2553 to elect treatment as an S-Corporation. This must be done no later than 2 months and 15 days following the beginning of the tax year you want the election to be effective. When filling out this form it is recommended to work with your tax professional. The taxes are reported in a similar manner to partnerships, using pass-through taxation. The business files form 1120-S where it reports income and expenses. The return creates K-1 forms that are distributed to each shareholder/member. This K-1 forms lists the shareholders individual proportion of the business’s income/expenses according to their ownership interests. This is reported on the individual taxpayers Sch. E with their Form 1040. The main difference is the applicable taxes to the individual. The IRS requires each participating(meaning actively involved in the business) shareholder to receive a “reasonable” salary for the job performed within the company. The individual pays payroll taxes on this salary as we discussed in the Sole Proprietorship section. The business pays the employer portion and the shareholder pays the employee portion. Since the worker is also an owner of the business, they effectively pay all 15.3% of the payroll/self-employment taxes on this income. The wages received will be reported when you receive a Form W-2 from the business. This is reported as ordinary wage income on your individual tax return. Any other money pulled out of the company and distributed to shareholders is only subject to the individual’s federal and state income taxes. Therefore, the shareholder saves 15.3% in taxes on the additional income distributed from the business outside of their salary. The key is in setting an appropriate salary for yourself. If you set the salary too low and send out most of the income through distributions, the IRS may recharacterize some of these distributions as salary/wages and require payment of the payroll taxes due on that income. This will lower your tax savings and cause administrative burden as you work through the determination with the IRS.

S-Corporations receive these tax benefits but are subject to some additional rules. The S-Corp structure was formed to spur small business creation. Therefore, the number of shareholders is limited to no more than 100. A husband and wife can be owners and considered one shareholder. Further, all members of a family are considered one shareholder. There are limitations to who can be a shareholder. Individuals, Estates, Exempt Organizations and some trusts are the only type of shareholders allowed for S-Corps. For individuals you must also be a U.S. Citizen or Resident. Only one type of stock is allowed to be issued for S-Corporations. If the only difference between two types of stock is voting rights, they are considered the same. Banks, insurance companies and domestic international sales companies cannot be owners. Each shareholder/owner must consent to the election for S-Corporation status. Generally, the S-Corporation must have a calendar tax year. There are certain exceptions to the calendar rule. If interested in filing for S-Corporation status, you should consult your tax professional to make sure it is the right fit for you. Finally, the processing of payroll will require you to file quarterly/annual payroll tax reports and remit payment to the appropriate federal and state agencies. This can normally be done by a payroll professional for a reasonable fee.

Business use:

               You are a freelance consultant who generates $100,000 in consulting fees throughout the year. You decide to form an LLC and file Articles of Organization with the state. Once your LLC is formed you will file form 2553 to elect S-Corporation status. For this example, we will assume you are a single tax payer using the 2022 tax brackets. After researching similar consulting jobs in the marketplace, you determine $55,000 is an appropriate salary for your work. The total payroll/self-employment taxes you will pay on this income is $8,415 ($55,000 X 15.3%). Half of this payroll tax ($4,207.50) will be deducted from your wages; the other half will be paid by the S-Corporation. The federal income tax is $7,717. After taxes you would receive net wage income of $43,075.50(disregarding state taxes in this example). The remaining $40,792.50 ($45,000 less the $4,207.50 paid in payroll taxes) you distribute from your business to yourself personally. You would not pay self-employment taxes on this income only federal and state income taxes. The federal tax would be $9,108.46. Since the remaining $40,792.50 is not subject to payroll taxes you save $6,241.25 ($40,792.50 X 15.3%).

Checklist for documentation/Implementation

1. ☐Articles of Organization/Incorporation.

2. ☐File form 2553 no more than 2 months and 15 days from the start of the tax year you want the election to be effective.
3. ☐Research and document your basis for determining a reasonable salary.
   1. There are some businesses that will do this research for you for a fee.
4. ☐Process quarterly/annual payroll forms and pay payroll taxes. (Federal, State and Local)
5. ☐Generate forms W-2 to record the salary and payroll taxes paid for the year by January 31^st of the following year.
6. ☐File form 1120-S Business tax return by March 15^th.
7. ☐ Distribute K-1’s to the appropriate shareholders.
8. ☐Report your share of wages, income and expenses on your individual tax return.

References:

1. What is an LLC? Limited Liability Company Structure and Benefits Defined (investopedia.com)
2. LLC Subchapter S Election: Everything You Need to Know (upcounsel.com)
3. What is a Subchapter S Corporation? – The Incorporators
4. The Advantages and Disadvantages of a Subchapter S Corporation (corpnet.com)
5. *Instructions for Form 2553 (Rev. December 2020) (irs.gov)
6. The History of LLCs - IncNow
7. What is Pass-Through Taxation? | ZenBusiness Inc.
8. Partnership Tax Return | UpCounsel 2023
9. Message from FreshBooks