Here’s Nine Things You Really Need to Know Regarding S Corporations and Income Taxes
What is an S-Corporation?
An S-corporation is a corporation that makes a federal election to have the federal income taxes paid by its shareholders rather than to the Company. In most cases, S corporations do not pay any federal income taxes. Instead, all items of business income, losses, deductions and credits are passed through to the S corporation’s shareholders and are reported on the shareholder’s tax returns. The S Corporation reports these amounts on Schedule K-1 which is distributed to each shareholder to report his or her proportionate share of the earnings.
When Is the S Corporation Tax Return Due?
In general, the S corporation federal tax return is due on, or before, March 15th (or 2 ½ months after year-end). S corporation federal tax returns can usually be extended until September 15th (or 9 ½ months after year-end). If you miss this deadline, you may be subject to a late filing penalty.
S Corporations and Income Taxes
The beauty of the S corporation structure is the avoidance of double-taxation normally associated with the C corporation structure. In the C corporation structure income taxes are assessed at the federal level to the corporation, then assessed a second time to the individual shareholders upon the withdrawal of the net earnings in dividends. For example, let’s say your corporation makes $100,000 after expenses. Using an approximate tax rate of 30%, you would pay $30,000 in income taxes at the corporate level leaving $70,000. If you then took the $70,000 out of the Company, you would be taxed an additional $21,000 resulting in total income taxes paid of $51,000 or 51% of your earnings. In contrast, under the S corporation structure, you would pay a single level of tax on the earnings, or $30,000 only on the individual level. Keep in mind that this example is very simplistic as tax rates are only approximated and ignores other strategies that we can implement to help you.
S Corporation Distributions and Taxes
Perhaps the most common misconception associated with S corporations is how distributions are taxed. The fact is that generally they’re not. You are taxed on corporate earnings and not how much money you withdraw from the Company. Whether you withdraw only $1, or $1 million, has no effect on your taxes. You are taxed on your proportionate share of the earnings of the Company.
First Year S Corporation Tax Returns
Yes, you have to file a first year tax return, even if you didn’t do any business. This is where a lot of people go wrong; incorrectly thinking that if you didn’t do any business in the first year, you don’t have to file. Unfortunately, you do. And if you don’t you could be subject to a penalty you might otherwise have to pay.
Failure to Make the S Election Timely
Perhaps the harshest result that we see quite often is the failure of management to make a timely S corporation election. Generally, you have only 2 ½ months after inception to make the subchapter S corporation election, and if you forget to do it, you generally cannot make the election until the beginning of the following tax year. As a result, you may be subject to the double taxation associated with C corporations on your first year earnings. As this is a very common mistake, there are fortunately certain steps we can take to alleviate the problem if you qualify.
Payroll and S Corporations
One of the unfortunate downfalls of many S corporations is that the owners fail to take a payroll, incorrectly believing that if they didn’t make much, or if they had payroll from other sources, a payroll return isn’t required. If you didn’t take a payroll, you could potentially be subject to payroll taxes on what you should have paid in upon examination. Unfortunately, if you didn’t take a payroll … well there’s not much you can do about it now, except probably to correct it in the following year.
State Income Taxes and S Corporations
Most of what we discuss here revolves around federal income taxes, but there are state income tax issues to know as well. Certain states treat S corporations differently subjecting them to minimum or franchise taxes, or disregard the tax benefits associated with S corporations. It is not enough to simply form a corporation in a state with beneficial interests where you transact business in a state that taxes S corporations. In fact, you may be registered in one state, but be subject to taxes in another.
Termination of an S Corporation
The termination of an S corporation concerns the ending of the preferred S corporation status. It is not necessary concerned with ending the business, but rather the changing of the S corporation status to something different. Of most concern is the inadvertent termination of the S corporation, in which the Company has an event that terminates the S corporation status. For example, here in South Florida at CPAMiami™, many of our clients involve foreign persons. If an S corporation enters into an agreement to admit a foreign shareholder, the preferred S corporation status is lost and the corporation will thereafter be subject to taxation as a C corporation. Such results can be quite different, even disastrous, for everyone else.
These are just some of the more common considerations you need to know involving taxes and S corporations. Hopefully, you found this article helpful. The S corporation regime involves many different – these are just a few. There are always lots of mistakes by owners in meeting or maintaining the stricter requirements of this entity type. In many cases, if you have a problem, we can help. If you don’t think you have a problem, but are perhaps interested in lowering your taxes, we can review this with you as well.