Taxation of S Corporations - Finance

Introduction - s vs c corp

Self-Employment Taxes - C corporation vs S corporation

One of the main reasons people set up an S corporation or make the S corp tax election for their LLC is to save self-employment taxes.

The tax rate is 15.3% up to $102,000 and 2.9% on the rest. This can result in a big tax bill.

Owners of S corporations are taxed much more generously. Salaries and bonuses are still subject to income tax and self-employment tax but profit distributions (sometimes referred to as dividends) are only subject to income tax " there is no self-employment tax.

S corp owners can potentially save thousands in self-employment tax by taking the smallest salary possible and the rest of their income as distributions.

Why not pay yourself no salary and take out all the profits as distributions? That's a no-no Because the IRS insists that you take a 'reasonable' salary " if you don't they will tax your distributions as salary.

To find reasonable salaries many tax pros use independent websites such as Salary.com or Payscale.com

ExampleLet's say Amanda has a net income of $90,000 from her S corporation. If she receives all of the money as salary she will have to pay self-employment tax on the whole amount at 15.3%:

$90,000 x 15.3% = $13,770

If instead she pays herself a salary of $50,000 and this is a reasonable salary, and pays herself a dividend of $40,000 she will save herself $6,120 in tax:

$40,000 x 15.3% = $6,120

This strategy is not without drawbacks, however. Maximizing distributions may, for example, reduce what you are allowed to contribute to a retirement plan.

Finally, this loophole may disappear eventually and all entities may end up paying uniform self-employment taxes.

State Taxation of S Corporations - C corporation vs S corporation

Most states recognize that S corporations are pass-through entities and the shareholders are subject to state income taxes on their share of the profits.

Please note that some states do, however, require you to make an extra state-level S corporation election.

Some states do not recognize S corporations and tax them like C corporations. C corporation vs S corporation. Your corporation will still be an S corp for Federal tax purposes but not for state tax purposes.

Some states such as California, New York and New Jersey tax both the S corporation and the shareholders " a form of double taxation.

If you want to set up an S corporation or have your LLC taxed like one, contact your state income tax office and ask them:

Is a separate state S corp election required?How will my S corp be taxed?

So how does this affect your choice of entity? Remember that in some states S corps and LLCs pay different amounts of tax. The extra tax may be significant or it may be small. Find out before you take the plunge!

0