HOW IS AN S-CORPORATION TAXED?
As small business accountants, many of our clients have made the election to be taxed as an S-Corporation. An S-Corporation is not a legal entity. The S-Corporation will be formed as and LLC or a Corporation and then an election is made to be treated as an S-Corporation for tax purposes.
So, how is it taxed?
Well, the S-Corporation really isn’t taxed at the federal level. All of an S-Corporations items of income and deduction flow through to the shareholders and then the shareholder reports those items on their individual return. The mechanism by which this happens is the filing of Form 1120-S. This tax return is used to report the income, expenses and balance sheet of the S-Corporation, among other things. The flow through items that are to be reported to the shareholders are reported on Form K-1.
Income in two ways from the S- Corporation
As a shareholder of an S-Corporation, you are required to pay yourself reasonable compensation. That compensation will be reported to you on Form W2 in the same way that all other employees are treated. Note that this type of income is subject to social security and medicare taxes. This is the least tax efficient way to earn income from an S-Corporation so it is important to get this number correct.
The other way that shareholders get income is from the earnings of the S-Corporation after all expenses are paid. That also includes deducting the wages paid to the shareholder discussed in the preceding paragraph. This is the income that is reported on the K-1.
Earnings and Distributions are not the same thing!
The earnings calculated as income minus expenses flows through to the shareholder whether the income is taken out or not. If the cash is needed for the operation of the business, it can be left in for those purposes. The previously taxed earnings can be distributed without tax in a subsequent year as long as the shareholder has sufficient basis. The topic of basis is beyond the scope of this blog, but we can define it simply as cash invested by an owner plus previously taxed earnings that have not been distributed.
State Taxes
The taxation at the state level is not working in exactly the same way as it is for Federal purposes. For the time being, many states are allowing the S-corporation itself to pay the taxes on the earnings. When the return is prepared, the K-1 for the state will have some indication that the amount has already been taxed so should not be reported again on the individual return.
The reason for this is simple. It is being used as a workaround from the Trump tax package. That tax package limited state and local tax deductions to $10,000 per year. The limit was designed to offset tax cuts included in the package. The IRS ruled that having the S-Corporation pay the tax directly was an acceptable way of doing it and it could be deducted for federal tax purposes. In nearly all cases, it is advantageous to pay the taxes at the corporate level.
How is this different from a C-Corporation
Simply put, the C-Corporation is subject to tax at the corporate level. An active shareholder could receive W-2 Compensation in the same way as and S-Corporation shareholder, but would not receive a K-1. In order to get previously taxed earnings out of the corporation, the company would need to declare a dividend and write a check. This dividend would be taxable to the shareholders that receive the funds. Taxed first as a corporation and then again when received by the shareholders.
In Greenville, SC, most of our small business accounting clients have elected to be taxed as an S-Corporation.
The reason for this is simple, corporate liability protection exists but without the double taxation that is present with the C-Corporation.
Buying or starting a business?
If you are in the process of buying or starting a business or just have questions about your existing business, we can discuss the best way to handle these types of decisions and elections. Click on our schedule call button for a free discovery call to find out if working with our firm is right for you.