The S Corporation - How It All Works!

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The S Corporation - How It All Works!

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

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