S Corporations

ADVANTAGES OF SMALL BUSINESS CORPORATIONS OR SMALL BUSINESS LIMITED LIABILITY COMPANY (S-CORP.)  

The intention of this page is to 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 (hereinafter referred to as “S-Corp.”), has greater 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 greater 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. business 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: 

Unincorporated Business 

S Corporation/LLC S-Corp Owner 

$100,000 

Gross Income 

$100.000 

Gross Inc. of Corp. 

-50,000 

Deductions/Expenses 

-50,000 

Deductions/Expenses 

 

 

-30,000 

Salary of Stockholder 

$50,000 

Adjusted Gross Income 

20,000 

Adjusted Net Profit of Corporation 

X 15.3% 

½ SE Tax Rate 

X 15.3% 

FICA tax paid (15.3% of Federal) 

-7,650 

SE Tax 

-4,590 

FICA Tax 

50,000 

Total Taxable Income 

50,000 

Total Taxable Income 

11,680 

Income Tax 

11,680 

Income Tax 

$19,330 

TOTAL TAX 

$16,180 

TOTAL TAX 

 

TOTAL TAX SAVINGS 

$3,150 

Tax Savings 

For purposes of argument, the unincorporated business taxpayer is self-employed, unmarried and filing separately. The S-Corp. (or LLC) 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 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 individual income tax on his $50,000 of taxable income (15% on the first $17,850 and 28% for taxable income over $17,850.) Therefore, the final amount of 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 individual income tax rate according to his percentage share of ownership in the S-Corp. Thus, there is no double taxation of the corporate income in an S-Corp. 

All of an S-Corp.’s items of corporate income, loss, deduction, credit and non-separately computed income or loss pass through to the individual stockholder and become part of his own individual taxable income. If an S-Corp. makes a profit at the end of the year, 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. has 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. 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 individual taxable income for tax reporting purposes. The total federal individual income tax paid by the stockholder is approximately $11,680, the same as the unincorporated business. But the stockholder does not pay the large 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 greater tax savings than an unincorporated business because the owner/operator of this business, as a stockholder in an S-Corp. does not have to pay the 15.3% SE tax on all of the net income generated by the S-Corp. The stockholder pays the 15.3% FICA/FUTA tax only on the salary portion of his income. There is no SE tax and no FICA/FUTA tax on the “passive income” S-Corp. distribution to the stockholder. Any corporate net income and/or losses “pass through” to the stockholder and are calculated on his individual taxable income for tax reporting purposes. 
 
IMPORTANT: There are numerous additional (but simple) steps that 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, and consequences and benefits available to such choices of entities and tax elections. Call us at (520) 797-1400 for a free consultation to clearly understand these issues and available benefits. 

Comparison of the Major Business Entities:  

 

Sole Proprietorship 

Regular Corporation 

S Corporation/LLC S-Corp 

Liability 

Personal Liability- Personal Assets At Risk 

Limited Liability- Protects Personal Assets 

Limited Liability- Protects Personal Assets 

Continuity of Entity 

Limited- 
Termination Upon Death of Principal 

Perpetual-Survives Death of Principal 

Perpetual-Survives Death of Principal 

Transfer of Interest 

Restricted 

Free Transfer Unless Restricted by Agreement 

Free Transfer Unless Restricted by Agreement 

Taxation of Income 

Directly to Partners 

Double Taxation 

No Corporate Tax, No Double Tax, Reduces FICA Taxation 

Major Advantage(s) 

Simple, Low Cost at Start Up; But Large “Costs” in Risks and Exposure 

Limited Liability 

Limited Liability; No Double Taxation; Reduces FICA Taxation 

Major Drawback(s) 

Unlimited Liability; Personal Assets at Risk; Restricted Transfer; Limited Duration 

Greater Start Up Cost; Double Taxation of Income 

Not Every Corporation Qualifies for S Status; Alternative solution: Limited Liability Company 

 Please do not hesitate to contact us at (520) 797-1400 for a free consultation regarding these matters.