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The S Corporation - How It All Works!
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The S Corporation - How It All Works!

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  • 1. The S Corporation How It All Works! Presented By: Mark Borel, CPA Mark Borel & Associates, Inc.
  • 2. What is an S Corporation?
    • The S corporation was formed by Congress, for use by small business owners, offering the best characteristics of both a C corporation and a partnership
    • It has become the most popular business entity type in recent years
    • Numerous studies indicate lower overall taxes are paid when an S corporation is utilized.
  • 3. Common Characteristics of S and C Corps
    • Same liability protection
    • Separate legal entities
    • The owners are shareholders
    •   Long standing case law
    •   Easy transfer of ownership
    •   Broader range of deductible expenses
  • 4. Common Characteristics of S Corps and Partnerships
    • Neither entity pays tax on net income
    • Both are “flow through” entities, so net income and loss is reported on the owners’ tax return
    • Losses can be claimed up to the investment in the entity
    • Losses can be claimed against ordinary income
    • Different income types “keep their character” as they flow down to the owner (i.e., interest income, L/T capital gains, etc.)
  • 5. So How is an S Corporation Formed?
    • C corporation is formed with the Secretary of State
    • File an “S election” with the IRS (Form 2553)
    • - Filing deadline is 75 days from the first day of the
    • proposed S year
    • - In recent years, the IRS has approved late filing of S
    • elections, but no later than the extended due date of the
    • tax return
  • 6.
    • When owners plan to work for the company
    • Well suited for a single owner, and when owners are family members, or when the shareholders happen to be a few friends or acquaintances, and/or
    • When the company has no plans to attract investors by “going public”, and/or
    • When >10% owners plan to offer services such as consulting, accounting, engineering, law, etc. to the general public; Used to avoid classification as a “personal service corporation” (PSC) and 35% flat tax on net income, and
    • When owners desire to remove most of the profits from the company
    When Should an S Corporation be Used?
  • 7. But How Does an S Corp Work?
    • The S corporation files a separate, annual tax return, but does not pay tax on reported net income (Form 1120S)
    • Instead, tax on the allocable net income (or loss) of the company is paid at the shareholder level
    • If a shareholder works for the company, IRS requires them to take a salary
  • 8. How an S Corp Works (cont.)
    • A shareholder who is also an employee, reports two types of income on Form 1040:
    • - Salary income as an employee (Form W2)
    • - Investment income as a shareholder (Form K1)
    • Similar to Form W2, the company issues Form K1 to each shareholder for completion of their individual tax return
    • There is no tax withholding on flow through income
    • These two types of income are not taxed the same
  • 9. How an S Corp Works (cont.)
    • The tax rate that applies depends on the type of flow through income
    • The most common type is classified as “ordinary”, meaning no special reduced tax rates apply, but losses can be applied against other income (up to your investment)
    • FIT is assessed using the individuals graduated tax rate schedule at rates of 10-35%, which is lower than C corp rates
    “ Flow through ” income reported on Form K1 is subject to only federal income tax:
  • 10. How an S Corp Works (cont.)
    • Employment taxes are paid by both the company and the shareholder
    • Withholding rules apply to this type of income
    • FIT is assessed using the individuals graduated tax rate schedule at rates of 10-35%, which is lower than C corp rates
    • Payroll expenses are deducted by the Company
    “ Employment ” related income reported on Form W2 is subject to both federal income tax and employment taxes:
  • 11. Getting The Money Out
    • Because income is taxed at the individual level rather than the company level, money can later be removed as a distribution to the owner with no further tax consequences.
    • A distribution is simply a check written to the owner with no withholding, and coded to the shareholders’ equity account.
    • This procedural difference allows the owner of an S corporation to easily remove money, and manage (within reason) employment taxes paid on executive salaries.
  • 12. So How Much Salary Should I Take?
    • The IRS advises paying yourself a “reasonable” salary for the services you provide – similar to what you could earn elsewhere
    • IRS guidance on this subject is minimal
    • This allows for some leeway on setting executive salaries
    • Paying no salary will greatly increase the odds of an audit occurrence, and an IRS levy of employment taxes, penalties and interest on all flow through income.
  • 13. S Corporation: T ax Advantages
    • No double taxation of distributions to shareholders
    • Income automatically flows to the shareholder level where tax rates are lower than corporate rates
    • “ Flow-through” income is subject to ordinary income tax rates, but not employment taxes.
    • “ Flow-through” income retains it’s characteristics, possibly qualifying for special tax rates at the shareholder level, i.e., 15% capital gain rate applied to long term capital gains
    • Income of the company is easily distributed to shareholders
  • 14. S Corporation: Disadvantages
    • Special limitations may apply on deductibility of employee/fringe benefits for >2% shareholders
    • Nondisclosure (privacy) of shareholders cannot be achieved from the IRS
    • Greater audit potential than C corporation due primarily to shareholders/employees not taking a salary
  • 15. Thank You For Attending!
    • Call 888-243-6555 to receive your complimentary whitepaper outlining a side-
    • by-side comparison of C Corporations vs. S
    • Corporations
    Presented by: Mark Borel, CPA, President Mark Borel & Associates, Inc.

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