Subchapter S Corporations

Subchapter S Corporations, or S corporations, have been in existence for many years. Recently, considerable discussion have been given to S corporations as a tax advantaged vehicle. While not for every business, the S corporation may provide significant advantages to certain small businesses.

The fundamental difference between the S corporation and the normal corporation, or C corporation, is the treatment of income. Rather than being taxed at the corporate level, the net income is taxed proportionately to the shareholders. As such, there is no "double taxation" as there is in a C corporation, where income is taxed at corporate rates when earned, and taxed to the individuals when distributed to the shareholder.

This tax planning tool comes with some restrictions. The Internal Revenue Service has placed the following restrictions on the S corporation:

1. The corporation must be a domestic corporation, originating in the United States. No foreign corporations are allowed S corporation treatment.
2. The corporation must have one class of stock. This restriction has come under close IRS scrutiny in recent years and must be carefully maintained. Even the payment of shareholder expenses for the benefit of one shareholder, while the other shareholders are not afforded the same treatment, can create two different classes of stock.
3. The must be no more than 75 shareholders.
4. Shareholders can be individuals, estates and certain trusts. No partnerships or corporations are allowed as shareholders.
5. Shareholders must be citizens of the United States or resident aliens.

The election to become an S corporation must be made by positive affirmation within certain deadlines. If the company is already a corporation, the election must be made two and one-half months after the corporate year-end. If the business is a sole proprietorship, the business must first incorporate under state law. Once this is accomplished, the election to become an S corporation must be made within two and one-half months. During the year of conversion for all businesses entities other than corporations, there will be two tax returns to be filed for the business - one for the old tax entity and one for the S corporation.

The tax form to be filed for an S corporation is the 1120S, which is due the 15th day of the third month following your tax year-end. The tax year for the S corporation is determined based upon the tax year-end of the shareholders. Due to the restrictions on the shareholders, most S corporation year-ends will be December 31. Another year-end can be chosen; however, substantial payments usually must be made for estimated tax.

As all income flows to the shareholders, there are no corporate tax rates for the S corporation. Each S corporation shareholder receives a K-1 at the end of the year that details the shareholders' ordinary income and other items of importance for the shareholders' personal tax return.

Shareholders of an S corporation must be concerned about their personal tax situation as significant amounts of income could be earned by the S corporation without any shareholder personal tax withholding being withheld. Each quarter, an individual should analyze the situation surrounding their overall tax picture and make appropriate estimated tax payments.

The potential tax savings for an S corporation does not stop there. As a corporate shareholder, each individual is entitled to a return on their investment. Additionally, employees are entitled to a reasonable salary. A determination must be made between these two portions. The portion determined to be dividends is not taxed as a salary but rather as dividends, creating tax savings in the form of payroll taxes.

For example, if a sole proprietor nets $50,000 in their business, all the net income will be taxed at the self employment tax rate, approximately 15%. As such, self-employment taxes will be approximately $7,500. In the same circumstances, an S corporation pays the sole shareholder $30,000 in salary and the remaining $20,000 of the total net of $50,000 is considered dividends. In this example, the $20,000 of dividends will not be taxed under self employment. This realizes a savings of approximately $3,000 when compared to the sole proprietorship.

The IRS, through case law, has provided certain guidelines in determining salary levels in an S corporation, as follows:

1. Except in certain start-up situations, the S corporation must pay some salary. A recent court decision disallowed the payment of no salary and approximately $18,000 in dividends.
2. The stock is owned by someone other than the working individual. This further justifies dividends being returned to the owner.
3. The working individual spends time on other activities.
4. The compensation paid is reasonable. This can be determined based upon salary studies or other reasonable information.
5. The characteristics of the local economy. If the business is in a depressed economy, this further justifies a reduced salary level.

The S Corporation is a tax tool that, if used properly, can reduce the overall tax burden to the shareholders and the corporation.

Grabau & Company, PC is a certified public accounting firm established in 1990 and located in Denver, Colorado. Please call our offices with any questions you have regarding material in this brochure or if you would like further professional advice on converting to an S corporation.