The S-Corp Tax Classification

The S-Corp Election is NOT an “Entity” choice.  It is a “tax classification” in Subchapter S of the Internal Revenue Code.  Nickname “S-Corp.”  Form 2553 is used to elect S-Corp Status.  Form 1120S and Form K-1 are used when filing taxes. 

Requirements of S-Corps: 

• be domestic corporation
• do not have more than 100 shareholders
• have only 1 class of stock.

Advantages of an S-Corp (get ready for number crunching):    

1. Avoid the alleged “double taxation” of Corporations. A Corporation’s profits (income after expenses, to simplify) are taxed at the Corporate Rate of 21%.  Post-tax profits are then available to be distributed as “dividends” to Shareholders.  Dividends received by Shareholders are then taxed as the Shareholder’s income.  Two different entities with two different taxable events creates the appearance of “double taxation” especially when the owner of the Corporation is also the Shareholder.   Alas, that was the price to pay for having “corporate entity protection” until the Subchapter S-Corp.

S-Corps allow for profits and losses to pass through from the corporation to the shareholder without taxation at the corporate level.  Profits are only taxed once – at the individual tax rate, which could be higher than the Corporate Rate these days.    

2. Allows for Income to Shareholders to be segregated into Wages and Distributions

Owner/employees who are also Owner/Shareholders receive two types of payments from the Corporation: 

(1) employee wages, which are Corporate Expenses and which are subject to withholding, i.e. FICA tax with Employer matching ; and

(2) shareholder profit distributions or profit allocation without distribution.  These distributions are not subject to FICA tax or Employer matching.   But remember, too, that some “distributions” are more of “allocations” of income as the monies just stay in the corporate bank account to pay bills in January.  Better to distribute any monies in the account, then start the new year with a new capital contribution. 

NOTE:  Wages must be seen by the IRS as reasonable under the industry standard.  IRS does not appreciate the temptation to avoid FICA tax by calling income “distributions” instead of “wages.”  

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