The S corporation business structure offers many advantages, including
limited liability for owners and no double taxation (at least at the
federal level). But not all businesses are eligible and, with the new 21%
flat income tax rate that now applies to C corporations, S corps may not be
quite as attractive as they once were.
The primary reason for electing S status is the combination of the limited
liability of a corporation and the ability to pass corporate income,
losses, deductions, and credits through to shareholders. In other words, S
corps generally avoid double taxation of corporate income — once at the
corporate level and again when distributed to the shareholder. Instead, S
corp tax items pass through to the shareholders’ personal returns, and the
shareholders pay tax at their individual income tax rates.
But now that the C corp rate is only 21% and the top rate on qualified
dividends remains at 20%, while the top individual rate is 37%, double
taxation might be less of a concern. On the other hand, S corp owners may
be able to take advantage of the new qualified business income (QBI)
deduction, which can be equal to as much as 20% of QBI.
You have to run the numbers with your tax advisor, factoring in state
taxes, too, to determine which structure will be the most tax efficient for
you and your business.
S eligibility requirements
If S corp status makes tax sense for your business, you need to make sure
you qualify and stay qualified. To be eligible to elect to be an S corp
or to convert to S status, your business must:
– Be a domestic corporation and have only one class of stock,
– Have no more than 100 shareholders, and
– Have only “allowable” shareholders, including individuals, certain
trusts and estates. Shareholders can’t include partnerships, corporations
and nonresident alien shareholders.
In addition, certain businesses are ineligible, such as insurance companies.
Another important consideration when electing S status is shareholder
compensation. The IRS is on the lookout for S corps that pay
shareholder-employees an unreasonably low salary to avoid paying Social
Security and Medicare taxes and then make distributions that aren’t subject
to payroll taxes.
Compensation paid to a shareholder should be reasonable considering what a
nonowner would be paid for a comparable position. If a shareholder’s
compensation doesn’t reflect the fair market value of the services he or
she provides, the IRS may reclassify a portion of distributions as unpaid
wages. The company will then owe payroll taxes, interest and penalties on
the reclassified wages.
Pros and cons
S corp status isn’t the best option for every business. To ensure that
you’ve considered all the pros and cons, contact us. Assessing the tax
differences can be tricky — especially with the tax law changes going into
effect this year.