S-Corporations

Advantages of Small Business Corporations or Small Business Limited Liability Companies (S-Corps.)   

This page will show the tax benefits of incorporating as a Small Business Entity for tax purposes, whether as an S-Corp or Limited Liability Company (collectively referred to as “S-Corp”). This page is not intended to induce any prospective client into forming an S-Corp for tax avoidance. Nevertheless, the Supreme Court of the United States has held that as long as a corporation or LLC has a legitimate business activity, the Court will not look to the reason for its creation: 

“Whether the purpose [of forming a corporation or LLC] is to gain an advantage under the law of the State of incorporation or to avoid or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity.”Moline Properties, Inc. vs. Comm., 319 U.S. 436, 87, L.Ed. 1499, 63 S.Ct. 1132 (1943) 
 
Issue: 

Whether a corporation or LLC, electing to be treated as a small business corporation for tax reporting purposes (from now on referred to as “S-Corp.”), has more significant tax advantages and savings to its stockholders than an unincorporated business and the extent to which these tax advantages may be realized. 

Short Answer: Yes. 

The S-Corp. does have more significant tax advantages and savings to its owners than an unincorporated business (i.e., sole proprietorship) for tax reporting purposes. Under the current Internal Revenue Code, an owner (operator) of an S-Corp. Companies may realize these tax advantages by eliminating federal and state self-employment tax (SE tax) incurred by a Sole Proprietorship on all earned income liability and by reducing the social security (FICA) and employment (FUTA) tax liability to the distribution portion of the total income received by the business owner of the S-Corp. 
 
Discussion: 

This Memorandum will compare the following scenarios: 

For purposes of argument, the unincorporated business taxpayer is self-employed, unmarried and filing separately. The S-Corp. (or LLC) the taxpayer is a 100% stockholder, unmarried, and filing separately. These taxpayers depict the worst filing status available. 

Taxation of an Unincorporated Business: In the hypothetical situation above, the unincorporated business generates $100,000 in gross income, $50,000 in deductions/expenses, and $50,000 in taxable income. Instead of regular FICA and FUTA taxes, the taxpayer pays a self-employment tax (SE tax) of 15.3% on his total earnings, which equals $7,650 after deductions. (Note: the self-employment deduction only reduces the taxable income subject to the SE tax; it does not reduce the overall amount of taxable income subject to regular federal and state individual income tax.) Finally, the taxpayer pays approximately $11,680 for federal personal income tax on his $50,000 taxable income (15% on the first $17,850 and 28% for taxable income over $17,850.) Therefore, the total federal individual income tax and SE tax he owes for the year is approximately $19,330. 

Taxation of S-Corp./LLC Income: In contrast to the taxation of an unincorporated business, an S-Corp. is an entity whose corporate income is not taxed for federal and state income tax purposes in most circumstances. Instead, the corporate income of the S-Corp. “passes through” to the individual stockholder, who pays tax on the corporate income at the federal personal income tax rate according to his percentage share of ownership in the S-Corp. Thus, an S-Corp has no double taxation of the corporate income. 

All of an S-Corp.’s corporate income, loss, deduction, credit, and non-separately computed income or loss pass through to the individual stockholder and become part of his taxable income. If an S-Corp. Suppose he makes a profit at the end of the year. In that case, the stockholder pays the income tax at the individual income tax level, based upon the percentage share of ownership in the S-Corp, whether or not he receives any cash distributions. If the S-Corp. If there is a loss at the end of the year, the stockholder realizes this loss as a deduction against other income reported in this tax year. 

FICA Tax Consequences of S-Corp.: In the hypothetical situation above, the S-Corp. Generates $100,000 in gross corporate income, $50,000 in deduction/expenses and pays $30,000 salary. The salary amount only is subject to 15.3% FICA/FUTA tax ($4,590). The S-Corp. does not pay any SE tax, nor does the S-Corp. Pay any FICA/FUTA tax on the $20,000 of S-Corp. Distribution income to the stockholder. This S-Corp. The distribution amount is “passive income” and not subject to FICA/FUTA tax—this S-Corp. Distribution “passes through” to the stockholder and is included in his taxable income for tax reporting purposes. The total federal personal income tax the stockholder pays is approximately $11,680, the same as the unincorporated business. However, the stockholder does not pay the hefty SE tax because his income is not “self-employment” income, nor does the stockholder pay the 15.3% FICA/FUTA tax on all income realized. Therefore, the stockholder realizes a tax savings of approximately $3,150 over the unincorporated business for each year of operation. 

Conclusion: The S-Corp. Provides more significant tax savings than an unincorporated business because the owner/operator of this business is a stockholder in an S-Corp. It does not have to pay the 15.3% SE tax on all of the net income generated by the S-Corp. The stockholder only pays the 15.3% FICA/FUTA tax on the salary portion of his income. No SE or FICA/FUTA tax exists on the “passive income” S-Corp—distribution to the stockholder. Any corporate net income and losses “pass-through” to the stockholder and are calculated on his taxable income for tax reporting purposes. 
 
IMPORTANT: Numerous additional (but simple) steps must be followed in order to receive and retain the Federal tax benefits available to an S-Corp. Therefore, it is vitally important to consult with your tax and legal document preparers to better understand the choices, consequences, and benefits available to such entities and tax elections. Call us at (520) 797-1400 for a free consultation to understand these issues and available benefits. 

Comparison of the Major Business Entities:  

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