I recently had the honor of teaching an accounting seminar for the Mandela Washington Fellowship program at Northwestern University last week. For one, this fellowship is amazing and the African Entrepreneurs that are participating in the Northwestern program have a wealth of experience that was inspiring to listen and learn about. We had a discussion during our seminar regarding taxation. The students in this fellowship came from a wide variety of African countries, of which some had fairly corrupt tax practices. The students wanted to know how the United States tax laws worked and do companies actively evade or avoid taxes. My response to them is that companies do not evade given that it is against the law to do so, but companies do not want to pay one cent above what they are legally required to. Some companies try to jump through loopholes, but those tend to be closed very quickly. So companies will try to do things that the US tax code rewards with specialized credits, like research and development, or take advantage of the few breaks available to them in the tax code. One of the best tax breaks available to small businesses is the S Corporation tax status.
Before we go into the tax breaks the S-Corporation gives you, lets talk about what constitutes an S Corporation. The S Corporation is a tax designation status that can be elected by LLCs and C-Corporations and be formed under certain state laws where applicable. To qualify for S Corporation status, the corporation must meet the following requirements:
- S Corporations are limited to 100 shareholders or owners. For the purpose of determine what constitutes a shareholder in this circumstance, family members who each own individual shares are considered one shareholder collectively. This definition was put in place so that S Corporations who were at or near the 100 shareholder limit would not be in non-compliance if a family member passed away and gave shares to multiple decedents.
- All shareholders or owners need to consent to the election to be taxed as a S Corporation.
- There can only be one class of shares in S-Corporations. This is defined for this purpose as all shares of a corporation have identical rights to distributions and liquidation proceedings. If there are two classes of shares in a company where one is voting class and the other is non-voting class and they both have identical rights to distributions and liquidation proceedings, that is allowable under the law.
- All shareholders must be citizens or residents of the United States.
It is also important to note that S Corporations have pass through taxation, meaning the company does not pay taxes for the net income of the company, but that net income is passed through to the shareholders of the S Corporation to report and pay taxes on through a K-1 statement issued by the S Corporation.
The major tax advantage the S Corporation has is that net income that is passed through to the owners is not subject to self-employment taxes, pursuant to the notion that employee owners of the company are paid reasonable compensation. Reasonable compensation is a term that has been widely litigated in tax court and very complex, so to simplify for our purposes here, reasonable compensation is what the shareholder employee would have been paid if they were an employee at another company or what someone with they same relative experience and duties would get paid had they done the job. Other employees salaries are also considered here, so it would be very inconsistent if the administrator or janitor had a higher salary than the shareholder employee had who was working as the President of the company.
Here is an example of the tax saving elements of the S Corporation. Lets say Bob is the sole shareholder of a LLC that makes widgets. Bob has multiple employees and no other employee has salary above $35,000. Bob files his 1040 tax return as married filing jointly. For the tax year ended 2014, the company had $100,000 of net profits. Since the company is an LLC, it does not pay Bob any wages and instead Bob is taxed personally on Schedule C for all of the $100,000 of net profits. Bob would pay income tax on the net profits of $100,000, which would result in an income tax of approximately $16,600. Bob would also have to pay self-employment taxes of 15.3% on the $100,000; which amounts to approximately $15,000 (taken into consideration the SE tax above the line deduction). Bob’s total tax liability for 2014 is $31,600.
Bob decides to make a S Corporation election for tax purposes as of January 1, 2015. For the 2015 tax year, the company has $100,000 in net profits before paying Bob’s wages via a W-2 to him. Everything else regarding the company has remain constant from 2014. Given the performance of the company, what his employees make, and what someone else would make in his position, Bob determined that his salary for the year is $60,000. Bob’s tax situation is very different this year than it was last year. For starters, by Bob receiving a formal salary from his company, he has to pay payroll taxes as well as the company totaling 15.3% or $9,180 of which half is a reduction of cash in his pocket and the other half is a business expense. Since S Corporations are pass through for tax purposes, Bob will still be paying income taxes on the $60,000 of wages as well as of the net income from the company, which is $35,410 (100,000 minus $60,000 in wages, minus 1/2 of the payroll taxes of $9,180, or $4590). His total income taxes amount to approximately $15,500. Since the company is a S Corporation, it does not pay self employment taxes on the $35,410 in net income being passed through to Bob on his personal tax return. Therefore Bob’s total tax liability for 2015 is the income taxes he paid as well as the payroll taxes he paid, which is $24,680 for the year. By being an S Corporation, Bob saved $6,920 in taxes in 2015.
The S Corporation election is an amazing way to get tax benefits for your company; however, making a S Corporation election is not for all companies. If you are getting outside investment from venture capital or other investment funds, they typically do not make investments in pass through tax entities, like the S Corporation. Also, becoming a S Corporation for tax purposes is not a switch that you can switch on and off as you see fit. There are some tax consequences to be revoking your S Corporation status that you need to investigate. There are also additional costs attributable to being a S Corporation, like filing a corporate tax return and needing to have a formal payroll process in place. Many single member LLCs make this election without knowing the additional cost and compliance that is necessary. Also to note that if you do not elect S-Corporation status for your current tax year by March 15, you will need to request a late election and hope the IRS in its good graces approves that.
S Corporations, if done correctly and if they follow the rules and reasonable compensation guidelines, can have significant tax advantages. Before electing S Corporation status, talk with your accountant to make sure it makes sense for your company.