What is the S-Corporation?
Generally, an S corporation does not pay income tax; however, its income, deductions and credits are passed through to its shareholders. The shareholders of an ‘S’ corporation on their tax returns include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of income or loss in the business. A ‘S’ corporation must file Form 1120-S, tax return for an s corporation if:
❖ it elected to be an S corporation by filing Election by a Small Business Corporation
❖ the IRS accepted the election, and
❖ the election remains in effect
Advantages: Double taxation is avoided
Double taxation occurs when a corporation pays income tax on corporate net income, and then the shareholders pay tax on any dividend income they receive from the corporation (This often occurs with C corporations). Double taxation hits particularly hard when a company is sold.
By becoming an S corporation, profits and losses flow directly through to the owners in proportion to their ownership percentages. For example, a 10% owner would receive 10% of the profits or losses.
Since profits and losses flow through and are taxed on the individual, there is no federal tax on the corporation itself. California does tax S corporations on the corporate level, but at much lower rates than C corporations. The remaining income flows through to the shareholders for a second layer of California taxation.
Advantages: Avoidance of self-employment tax by the shareholder of the corporation:
Sole proprietors and independent contractors are subject to self-employment tax at a rate of over 15%. A self-employed person who forms an S corporation and becomes an employee of that corporation is no longer subject to self-employment tax because that person will no longer be self-employed. This applies even if that person is the corporation's sole shareholder and employee.
However, reasonable wages are required to be paid to the shareholder/employee and payroll taxes must be paid on this amount.
The profits of an S-Corporation automatically pass to the shareholders of the corporation each year. This means that any income earned by the corporation is automatically passed to its owners and included as taxable income for the shareholders. Most owners of corporations choose to file for S-Corp status to avoid the possibility of double taxation. A S-Corp must have fewer than 100 shareholders to qualify as a S-Corporation.
Most small business owners naturally will avoid double taxation by paying out income in the form of salary and bonuses. Both salary and bonuses, and any other form of employee compensation, are direct reductions from the net income of the corporation, hence taxing the owner only once, at the individual level.