Subchapter “S” Corporation: Legal Attributes

Again, Corporations are governed by the California General Corporation Law under the California Corporations Code, Title 1.  A corporation that elects to be treated under subchapter “S” of the Internal Revenue Code (“IRC”) is colloquially referred to as an S-corp.  Notably, the traditional corporation is referred to as a C-corp because–you guessed it, it is governed by subchapter “C” of the IRC.  Put in another way, the S-corp entity form is treated as a California corporation from a legal standpoint, but for tax purposes it is treated as an S-corp. An S-corp is a corporation that is considered a pass-through entity for federal tax purposes. The eligibility requirements to elect S-corp status include: be a domestic corporation; limited to 100 shareholders; shareholders must be individuals, estates, certain trusts, or tax-exempt charitable organizations; shareholders must be U.S. citizens or permanent residents of the U.S.; and corporation can have only one class of stock.  Indeed, due to eligibility requirements, corporations, LLCs and partnerships cannot be shareholders of S-corps.  In essence, an S-corp enjoys most of the benefits and protections of a C-corp without being subjected to the dreaded double taxation.

S-Corp: Formalities

Same as C-corp formalities with the addition of filing for subchapter “S” election using IRS form 2553 within 2 months and 15 days of incorporation.

S-Corp: Formation Start Up Cost

Same as C-corp. Please use the following Comparison Chart for side by side comparison.

S-Corp: Tax Attributes

An S-corp is a corporation that is considered a pass-through entity for federal tax purposes.  That is, income generated by an S-corp is taxed once at the shareholder’s respective federal income tax rate based on his/her proportionate share of the corporation’s stock. Essentially, this is what distinguishes an S-corp from a traditional corporation (C-corp)–the business entity is not taxed itself, only the shareholders are taxed.

Although the S-corp is exempt from federal taxation, at the state level a California S-corp is subject to 1.5% tax on income (C-corp is subject to 8.84%).  The caveat still applies, however: after the first year of business, the corporation is subject to a minimum $800 tax (franchise tax fee) regardless of whether the corporation produced any income.   Once the business expenses, state taxes, and salary to the active shareholder/owner for their services have been deducted, the remaining balance is distributed to the shareholder/owner (the “distribution”). This is because a shareholder/employee wears two hats: First, he is a shareholder (investor) who is entitled to expect a return on his investment, i.e., distribution. Second, he is an employee who performs services for compensation, i.e., salary.

Accordingly, it should come as no surprise that the remaining balance that passes through to the shareholder as a distribution will then be subject to both state and federal personal income taxes.  It should be noted that the distinction between a distribution and salary is an important one; both a distribution and salary are subject to state and federal personal taxation, however, a salary is subject to an additional self-employment tax of 15.3%.  This self-employment tax consists of a 12.4% Social Security tax on the first $118,500 of net salary and a 2.9% Medicare tax which applies to the entire salary.  Additionally, some taxpayers face an additional Medicare surtax of 0.9% of Medicare wages or self-employment income exceeding $250,000 for married couples or $200,000 for singles.  You may be asking yourself, why would someone ever claim a salary if he/she could avoid the self-employment tax by taking all profits in the form of a complete distribution; well that’s because there is this important caveat: any shareholder who actively works for the company must pay him or herself “reasonable compensation.” The shareholder must be paid fair market value for his services, or the IRS might reclassify any additional corporate earnings as “wages.”  The general rule of thumb is that the IRS will scrutinize an S-corp owner if they pay themselves a salary less than 25% of the total profits.

Due to the structure of the federal income and corporate tax rates, as long as an S-corp has an income over approximately $75,000, and barring special circumstances, it will almost always pay less income tax than a C-corp.

Furthermore, as a pass through entity, an S-corp can take advantage of the preferential long-term capital gains rates on capital assets. See IRC 1201. In contrast, unlike individuals, who enjoy preferential tax treatment for long-term capital gains, C corporations do not get preferential tax treatment for long-term capital gains. With the C-corp, long-term capital gains are simply added to the corporation’s ordinary income along with other income items and taxed at the corporate tax rates.

Notably, some determined business owners who are familiar with C-corp retained earnings (which provide for deferred distribution taxes) may question whether it is possible to avoid the entity level federal tax by filing for “S” chapter election while still retaining earnings to effectively avoid both level of taxes until future distribution in subsequent years.  Although this strategy would seem most beneficial, retained earnings by an “S” corp are nevertheless subjected to both federal and state taxation regardless of whether they were actually distributed to the shareholder/owner. Theoretically, the shareholder/owner could retain the earnings in the “S” corp after paying the appropriate taxes as if the earnings were distributed; however, the practical consequences would be similar to the shareholder/owner giving a contribution to the entity and increasing their basis in the shares resulting in this amount being exempt from future taxation when distributed.

Consequently, this entity is treated as a California corporation from a legal standpoint, but for tax purposes it is treated as an S-corp.

Please use the following Entity Selection Tax Cheat Sheet to predict your tax liability.