The S Corporation

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As I discussed in an earlier post, there are significant tax disadvantages of operating a business as a C corporation, most notably the existence of double taxation. That is to say that corporate profits are subject to taxation with a top rate of 35% at the corporate level and then are against subject to taxation with a top rate of 20%—not counting the additional 3.8% rate imposed by ObamaCare—at the individual level.

This, of course, makes the corporate form very undesirable for most small businesses. For this reason, Congress has provided for the existence of special types of corporations that are not subject to taxation at the corporate level. Instead, profits are passed through to shareholders to be taxed at each shareholder’s individual level.

Limitations of S Corporations

The S corporation exists primarily to ease the tax burden on small businesses, though there is no requirement that only a small business may take advantage of its provisions. (S corporations cannot go public, however, and so large businesses rarely operate in this form.)

Because of its special tax benefits, S corporations are subject to special rules that do not burden C corporations. These rules include:

1. There may not be more than 100 shareholders, though members of the same family may sometimes be considered to be one shareholder for this purpose.
2. All shareholders must be individuals—LLCs or other corporations, for example, cannot hold shares in an S corporation—and all shareholders must be American citizens.
3. An S corporation can only have one class of shares, and every share must have the same economic rights as any other shares. An S corporation cannot, for example, have both common shares and preferred shares, as many C corporations do.

S Corporation Taxation

As stated early, the profits of S corporations are taxed at the level of the individual shareholder only. Unlike the shareholders of C corporations, however, shareholders of S corporations are taxed on their share of the profits rather than the profits they actually receive.

Profits retained by the corporation are still subject to taxation at the shareholder’s individual level. This alone can make it an undesirable business form for larger businesses.

One significant advantage of S corporation taxation, however, lies with the payroll tax. S corporations can both pay its owners a salary for their work, which is taxed as income, and distribute dividends. Dividends, unlike salary, are not subject to payroll taxes, which can be quite significant (more than 14% for self-employed individuals).

Therefore, owners of S corporations who also participate in its operation can pay themselves a reasonable salary—on which they must pay payroll taxes—and then distribute any excess profits to themselves as dividends—on which they do not have to pay payroll taxes.

The key word here, however, is “reasonable.” While the IRS has not issued clear guidelines, salaries that are unreasonably low for the market will not be accepted. So, for example, were a doctor to operate his own practice as an S corporation and pay himself a salary of $10,000 per year and distribute dividends of $150,000 to minimize payroll taxes, the IRS would likely disallow this allocation and assess penalties and interest.

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See Also:

The Corporation

The Benefits of Partnership Taxation