An S corporation is a corporation, just like a C corporation. Its shareholders enjoy the same general shield from personal liability for the corporations’ acts or omissions. The major difference lies in the tax treatment of the S corporation. As stated, C corporations are subject to taxation at the corporate level and the shareholders are then subject to taxation on that same stream of revenue when distributed in the form of dividends. By contrast, S corporations avoid double taxation since only the individual shareholders are taxed. S corporation status is achieved by electing such tax treatment after organization (IRS Form 2553). Net profit or loss after expenses for S corporations, including salaries paid to employees and shareholder-employees, is reported on federal Form 1120S and “passed through” to shareholders’ personal tax return via Schedule K-1, where it is subject only to ordinary income taxes. Additionally, pass-through losses are limited to the taxpayer’s basis in the stock of the S corporation, Click regarding members of a business.
All wages are subject to self-employment (payroll) taxes. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The S corporation will pay the employer’s share of FICA taxes (7.65%), and the employee will pay the other share of FICA taxes (also 7.65%). Between the S corporation and the shareholder, wages are subject to approximately a combined 15.3% payroll tax, plus the shareholder’s income tax rate. So all things considered, the shareholder-employee should pay only a minimal salary to themselves in order to decrease the amount of taxes paid on corporations’ profit stream. IRS rules do require that reasonable salaries must be paid to shareholder-employees (the failure to do so is considered by many to trigger an internal audit). But, all other earnings avoid self-employment taxes and are subject to either ordinary income or capital gains. This means the payroll taxes would have to be paid on reasonable salaries (wages) of employee-shareholders only, and not the S corporation’s distributions.
When do you need to pay wages? According to the IRS, reasonable compensation is determined by what the shareholder-employee did for the S corporation. The IRS will look at the source of the S corporation’s gross receipts: 1) services of shareholder, 2) services of non-shareholder employees, or 3) capital and equipment. If the gross receipts and profits come from items 2 and 3, then no compensation needs to be paid to the shareholder-employee. However, if most of the gross receipts and profits are associated with the shareholders personal services, then most of the profit distribution should be allocated as compensation. (Of course, you should ask an accountant for more details).
Even if income is not distributed to the shareholders and left as operating capital, it will still be taxable to the individual shareholders. This is because all income is passed through to the shareholders automatically. Shareholders in a C corporation are only liable for taxes on dividends they actually receive (but, undistributed income of the corporation is not subject to self-employment taxes).
Among other key differences, S corporations are less flexible than C corporations and LLC’s. Only a limited number of shareholders, usually only individuals, and no foreign shareholders are allowed. In this sense, S corporations are typically more suitable for small and closely held businesses who do not seek to raise large amounts of capital publicly. As with a C corporation, shareholders own the corporation by virtue of their stock in the corporation. However, there can only be one class of stock with respect to distribution rights, unlike a C corporation.
S corporations are generally suitable for active businesses with little debt, no high risk assets and low chance for substantial appreciation since all corporate earnings are typically distributed to the shareholders.