You may have been advised that you could become an S corporation and save the "double taxation" problem of being a shareholder in a corporation. Yes, an S corporation is taxed in a different way from corporations, and the owners of an S corporation don't have the double taxation problem, but before you decide to elect S corporation status, you should understand how an S corporation pays income taxes.
S Corporations Explained
An S corporation (S Corp) is a special kind of corporation which operates as a corporation but is taxed on the individual shareholders' tax forms, for federal income tax purposes.
In order to become an S corporation, a business:
- must be a corporation
- must meet some specific requirements and then
- must file an election form with the IRS.
S Corporations and Federal Income Taxes
For tax purposes, an S corporation is considered a pass-through taxing mechanism. That is, the tax on the S corporation is passed through to the owners for federal income tax purposes.
- First, the corporation files a business tax return on Form 1120-S.
- Then each shareholder's share of the profit or loss of the corporation is recorded on a Schedule K-1.
- The K-1 information for each shareholder is reported on Schedule E of the person's individual income tax return.
Most states use federal information to determine total income for state tax determination.
How S Corporation Owners areTaxed
The owners of the S corp pay income taxes based on their distributive share of ownership, and these taxes are reported on their individual Form 1040. For example, if the profits of the S corp are $100,000 and there are four shareholders, each with a 1/4 share, each shareholder would pay taxes on $25,000 in profits.
A Special Tax Deduction for S Corp Owners
Like other pass-through businesses, S corporation owners may be eligible to take a Qualified Business Income Deduction (QBI) to deduct up to 20% of their business income (with certain qualifications). This deduction is in addition to the normal business expense deductions the S corporation can use to reduce its taxes The QBI deduction is taken off the owner's tax return, not the business return.
S Corps Avoid the Double Taxation Problem
Double taxation is an issue with corporations, where the net income of the business is taxed and the shareholders are taxed on their dividends In an S corp, the income tax is paid through the owners in their personal tax returns. No tax is imposed on the S corp, and there are no dividends.
S Corporation Owners and Taxes
The owners of an S corporation pay regular income tax on their distribution, but they are not considered to be self-employed, so they pay no self-employment tax on this distribution.
If any of the owners also are employees, they receive a salary, from which FICA taxes (Social Security and Medicare tax) are withheld.
Many S corp owners work in the business and some try to avoid taxes by not paying these people as employees. The IRS watches closely to make sure they receive reasonable compensation for their services, including paying Social Security/Medicare taxes on this income.
Other Taxes Paid by S Corporations
The S corporation pays the same taxes as other businesses, including:
An S corporation must pay employment taxes on employee pay, including withholding and reporting federal and state income taxes, paying and reporting FICA (Social Security and Medicare) taxes, worker's compensation taxes, and unemployment taxes. Also, if the S corporation owns a building or other real property, property taxes are required to be paid on this property.
S corporations are required to pay state sales taxes and excise taxes in the same manner as other business types. Check with your state department of revenue for more information on sales and excise taxes.
Some states levy franchise taxes, state income taxes, or gross receipts taxes on S corporations each year. Check with your state department of revenue to see if your state requires these taxes.