At the outset, it is important to clear up one common misconception our San Diego business attorneys hear a lot: An “S Corporation” is not a type of entity which can be formed through the California Secretary of State’s Office. Unlike a C Corporation, an LLC or LLP, an S Corporation is a type of tax election a company may make with the Internal Revenue Service, which indicates the owners have chosen to be taxed in a way which is different from the default treatment by the IRS for their type of entity. For example, by default, the IRS treats a C Corporation as a separate entity, which means it profits are taxed based on corporate tax rates, not the rates its owners are subject to. However, if the C Corporation’s controlling documents permit an S Corporation election to be made and the board/shareholders do elect to have the company treated as an S Corporation for tax purposes, then the profits and losses of the corporation will pass through the shareholders’ personal tax returns, avoiding the potential for double taxation of profits.
Summary of Default Tax Rules for Common Types of Entities
As indicated above, a C Corporation is normally taxed as a separate entity based on a corporate tax table. Payments to shareholders are then subject to taxes based on the individual income tax tables, leading to the potential for double taxation. In addition, any losses incurred by the C Corporation cannot be used to offset other income received by its owners.
For a single member LLC, the IRS disregards the entity altogether and the profits of the business flow through the owner’s personal tax return, which are subject self-employment taxes.
Similarly, a multi-owner LLC is taxed as a partnership by default and those profits flow through to the partners’ individual tax returns, which are also subject to self-employment taxes.
How are Companies Taxed if They Elect S Corporation Status?
Like a partnership, an S Corporation is a pass-through entity meaning that income and losses pass through the corporation to its owners’ personal tax returns. S Corporations also report their income and deductions much like partnerships. Where S Corporations differ from partnerships is the employment status of owners who work in the business. The owner of a multi-member LLC taxed as a partnership is not an employee of the LLC for tax purposes. He or she is simply a business owner.
In contrast, an owner of an LLC which has elected S Corporation status will be its employee for tax purposes, as well as an owner. In effect, an active owner of an S Corporation wears at least two hats: as a shareholder (owner) of the entity, and as an employee of that entity.
What is the Primary Benefit of Electing S Corporation Status?*
As your San Diego business attorney can attest, the answer is simple when it comes to C Corporations: the shareholders avoid the potential for double taxation. In addition, losses sustained by the corporation which has elected S Corporation status can offset other income its owners may report, making an S Corporation election helpful in reducing the owners’ personal income tax liability during the start-up phase of the company.
For single-member and multi-member LLC’s, the primary advantage of S Corporation status is this: S Corporation tax treatment can provide a way to take money out of your business without paying employment taxes. This is because you do not have to pay employment tax on distributions (dividends) from your S Corporation—that is, on earnings and profits that pass through the corporation to you as an owner, not as an employee in compensation for your services. The larger your distribution, the less employment tax you’ll pay. Therefore, an S Corporation tax election makes it possible for owners of LLC’s to save on Social Security and Medicare taxes. This is the main reason S Corporations have been, and remain, popular with business owners.
Does My Entity Qualify for S Corporation Status?
To qualify for S Corporation status, corporations must meet the following eligibility requirements:
- Be a domestic corporation or LLC
- Have only allowable shareholders or members
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders or members
- Have only one class of stock or ownership interest
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international saleS Corporations).
Here is a link from our San Diego business lawyers which provides additional information on S Corporation election requirements in California:
The business entity formation attorneys at Gehres Law Library can assist you in setting up your new company and deciding whether to elect S Corporation status. Contact us today for a free evaluation or browse our website for more information.
*For more advanced tax planning advice, speak with a tax professional about your specific needs.