Many people always talk about the tax advantages of the S-Corp versus a traditional C-Corporation or other entities as an LLC, or LLP. In general, the S-Corp is a corporation designed for small to mid-tier businesses who do not have to deal with the tax and accounting complications of a C-Corporation as avoiding the risk of double taxation, declaring dividends, additional taxation on excessive executive salaries, etc. combined with the corporate protection separating the business assets from your personal assets, just like a traditional C-Corporation.
So, how does an S-Corp work? First, the S-Corporation is a flow-through entity. A flow-through entity is an entity where the company is not taxed on the business income, however, the business income is taxed based on the shareholder(s)/owner(s) percentage of ownership in the company. For example, let’s say Hi-Tech, Inc. business income for 2015 was $500,000 and it had two shareholders whom each owned 50% in the company. So, Hi-Tech, Inc. pays no Federal income taxes, however, each owner has $250,000 in income to report and pay income taxes on their personal return from their S-Corp income. Otherwise, the company does not get taxed, but the business owners do.
Avoiding Double Taxation
So, why is it advantageous that just the business owners get taxed. First, they avoid double taxation. Double taxation, is when both the corporation taxable income is taxed and the dividend income is taxed by the business owner. This is the model for the C-Corporation. The only way this can be avoided at year end by a C-Corporation is precise accounting needs to be done to lower or significantly lower taxable income by shareholder(s)/owner(s) taking additional salaries, profit-sharing contributions, etc. This for many business owners is too complicated. The reason being is they do not have the in-house accounting resources to make the calculations, they do not want to pay for the tax accountant to make the calculations, it’s another thing that they need to do that interferes with them making money and instead they have to focus on additional administrative work, and finally ninety-nine percent of the time, they hate doing it. Because of this, instead of taking bonus salaries at year-end, the S-Corp owners do not have to worry about anything and do nothing.
Claiming Business Losses
The second advantage is claiming business losses the year that they occur. So, let’s say you are 100% S-Corp shareholder/owner, it’s your first year in business and you lose $100,000. The $100,000 loss can be claimed on your personal tax return as an active business loss. If your total income offsetting the loss was under $100,000 and let’s make it $50,000, then you would have a net operating loss of $50,000 on your personal tax return. You can either use this loss in future years as a net operating carryforward or offset income in prior years as a net operating loss carryback. Either with the carrybacks or the carryforwards more likely than not, you will be able to use the loss. However, if it a C-Corporation, the loss can’t be used unless it had income in prior years, or will have income in future years. So, let’s say you have a start-up, it’s taxed as a C-Corporation, has a loss of $100,000 the first year, $200,000, the second year, and ceases operations in the third year with an additional $150,000 loss, which is a cumulative loss for $450,000. Unlike an S-Corp these losses could not be used each year on the shareholder(s) personal tax returns, instead the losses stay with the corporation. So, when the corporation ceases operations, the only thing that could be claimed is a capital loss on the shareholder(s) personal return. The reason being they put $450,000 for the company and since it ceased operations, in effect they sold it for $0, creating a $450,000 capital loss. Unfortunately, with capital losses they are limited to $3,000 a year. The only other way to offset the capital losses is you would have to capital gains. Otherwise, if you do not have any capital gain income to offset the losses, then it would take 150 years to claim the losses on your personal tax returns for a $450,000 capital loss. So, to reduce this exposure to capital losses some start-ups begin as S-Corporations and then later convert to C-Corporations when they become profitable, or get a deal in Seed Funding, Preferred Stock, etc. that is only viable if the company converts to a C-Corp.
Payroll Tax Savings
The third major advantage and this is based on the shareholder(s) income that there could be payroll tax savings. First, with an S-Corp if you are active shareholder running the business, you are a shareholder/employee. Because you are employee, you are required to have payroll. So, the strategy is to allocate the S-Corp income where you pay the payroll taxes as an employee which is subject to both employer and employee payroll taxes, however, the S-Corp income is not subject to the payroll taxes. Not including unemployment taxes and CA SDI, the total Federal payroll taxes for both Social Security and Medicare for 2016 employer and employee contributions is 15.3% up to $118,500 and 2.9% for payroll over $118,500. How the 15.3% is calculated is social security totals 12.4% with 6.2% paid by the employee and 6.2% paid by the employer. For Medicare it is 2.9% with the employee paying 1.45% and the employer paying 1.45%. Otherwise, 12.4% plus 2.9% equals 15.3%. So, let’s say if your business made $100,000. If you split the income 50% to S-Corporation being $50,000 and $50,000 to salary, then your gross savings is $7,650 if you multiply 15.3% by $50,000. However, at the end of the day, the savings is reduced first by getting a tax deduction of 7.65% for the employer portion of Social Security and Medicare paid by the employer deducted off the S-Corp return. The other issue and will go into detail more later, is though the S-Corporation is not subject to Federal taxes, it is subject to CA taxes. The CA Franchise Tax Board (FTB) rules is an S-Corporation must pay the greater of $800 or 1.5% of its S-Corporation income every year. So, if you factor the employer payroll tax deduction, plus the 1.5% that is required to be paid to the CA FTB, at the end of the day the net tax savings is in the range of 10-12%, not 15.3% if your salary paid is under $118,500.
So, many people will state well I do not want to pay Social Security and Medicare, so why can’t I have 100% of the S-Corp income and not pay myself a salary. First, the rules are you are not only a shareholder, but more importantly an employee. Employee must be paid salaries. The second issue, is the IRS has criteria for paying salaries as an S-Corp owner. The most important provision is that you must pay yourself a “reasonable salary”. Per the IRS definition of a “reasonable salary”, if somebody hired you be an employee/manager for the business, how much would they pay you? So, you can’t be a consultant, S-Corp makes $200,000 a year and pay yourself a salary for $30,000. So, until you reach the social security threshold, either you pay a salary that is up to a manager’s salary within the rules of paying a “reasonable salary” or split the income 50/50, until you reach the social security threshold.
So, if you are an S-Corp owner and you have payroll tax savings if your salary is under the social security thresholds by not paying the payroll taxes is a “double-edged” sword. The reason I say this, is because you are reducing your social security contributions, by allocating your S-Corp income that is below the social security thresholds. By doing this, it will reduce your social security benefits when you retire. So, the suggestion is if you do this, is put all tax savings in a retirement account or another investment vehicle to use for your retirement. If you put the amounts in a retirement plan, it will reduce your income taxes as well.
Obamacare Earned Income Tax Savings
After you reach the social security threshold for $118,500 for 2016, then there is not any S-Corp savings if your S-Corp is located or doing business in California, except for a hedge to avoid paying Obamacare .9% additional taxes on earned income over $200,000 if you are single, and $250,000 if you are married. The reason being is you have to pay 1.5% in CA income taxes, plus the business does not get the 1.5% deduction for the employer paid Medicare taxes for 1.45% for salaries above $118,500 for 2016. So, the main savings is if you can claim the payroll tax savings, if your income is under the social security threshold. However, as a hedge even if your salary is over the social security threshold for $118,500, it still makes sense to allocate your income as salary and S-Corp income to avoid the .9% additional Obamacare taxes for earned income. For example, let’s say you are married, you have an S-Corp it makes $300,000 a year, you pay yourself a salary for $140,000, and the rest is S-Corp income for $160,000 and your spouse makes $100,000 a year. Because the total earned income between you and your spouse is $240,000, then you do not have to pay the additional Obamacare taxes at .9% on earned income. Currently, I am not aware of Congress proposing legislation to close-out this loophole, though there has been controversy throughout the years for getting rid of S-Corp shareholder/employee S-Corp income and salary allocations and making all S-Corp income subject to self-employed payroll taxes. However, many S-Corp owners are successful and many times are between the top 1% – 5% tax brackets, however, not in the top .1%. In this range, the owners will be paying taxes in the top tax brackets, and in my opinion definitely paying their “fair share”. In addition, they do not make the income, nor can they pay for the resources to avoid income as the top .1%. Because of the outcry for closing out this loophole from small business owners, in my opinion this loophole hopefully will never be “closed-out”. Otherwise, the IRS is allowing the S-Corp owners get their 5% Target discount if they use the Target credit card, and not having the luxury to pay Dollar Tree taxes.
Single Member LLC
So, does S-Corp make sense for all business owners. The answer is no. The first example I want to present is a Single Member LLC. The Limited Liability Company (LLC) is not recognized by the IRS as a taxable entity, but is recognized as a business entity by state law. By default, a Single Member LLC is taxed as sole proprietor or a Multiple Member LLC is taxed as a partnership. However, both the Single Member LLC and Multiple Member LLC have the option to either make the election to be taxed as either an S-Corporation or C-Corporation. So, many people start a business the form a LLC versus a S-Corporation or C-Corporation, because they hear it’s the best entity to start out with and many times do not get formal tax nor legal advice from either a tax professional nor an attorney and setup a Single Member LLC using a do it yourself incorporation service. In addition, the first year of business they have either a loss or make little income. In this case, it may make a lot of sense for the person who setup the LLC to be taxed as an S-Corp later down the road. First, at the beginning many times the businesses have either losses or little income. Because of this, there really isn’t payroll much tax savings. In addition, there is another administrative burden for the owner having payroll. So, at this point because there is more administrative burdens and there is little or no payroll taxes being an S-Corporation, it does make sense for the company to stay as a Single Member LLC taxed as a sole proprietor. However, later down the road for potential payroll tax savings it does make sense to be taxed as a S-Corporation. In my opinion from purely a tax perspective it makes sense for a Single Member LLC to be taxed as an S-Corporation if reaches an income for $75,000 or greater in a year. Until it reaches this benchmark, it probably does not sense for the business to make S-Corporation election. However, even if the business makes S-Corporation as previously stated, that payroll tax savings should be used to contribute to a retirement plan or other investment savings vehicle for one’s retirement, because the allocation between S-Corporation income reduces Social Security contributions, which will reduce Social Security benefits when one retires.
Multiple Member LLC
Multiple Member LLC’s are more difficult for considering S-Corporation or C-Corporation since there are multiple decision makers and also certain investment vehicles that people make with multiple member LLC’s. First, you have more parties involved when you make a decision. This makes it harder to make a decision whether it makes not only tax sense but business sense since every LLC member situation is different. Second, is what is the LLC type of business. If the LLC has a business that has passive income as real estate, then it’s can’t be taxed as an S-Corporation. The reason being is S-Corporations are designed to have active, not passive income with shareholder/employee salaries and it’s limited to only 25% of its gross receipts to be passive income. This could be a big issue for real estate that in general is considered passive income, unless it is a real estate management company. In this case, then it makes sense for the multiple member LLC to not make S-Corporation election and be taxed as a partnership.
Summary
The advantages of an S-Corporation are it not subject to double taxation of Federal taxes and S-Corporation CA income tax is 1.5% versus C-Corporation tax at 8.84%, losses can be claimed the year they incur on the S-Corp shareholders personal tax returns, there is potential payroll tax savings allocating S-Corporation income, and it can be used as a hedge to avoid Obamacare .9% earned income tax. The disadvantages are it can be more complex and administrative of other entities as a Single Member LLC, it does not allow foreign shareholders, it is limited up to 100 shareholders, and it only allows one type of common stock, which is not good for start-ups that get seed and venture capital financing which usually has investments in preferred stock, warrants, etc. So, the S-Corporation can be an advantageous business and tax entity, however, all business owners need to do their research to determine whether they should either start a business that is an S-Corporation or that can be taxed as an S-Corporation with S-Corporation as a Single Member LLC.