Sub Chapter S Corporations
This week, I would like to continue a discussion of the various entities that are available to taxpayers who are starting a business. In the past weeks, I have written that a Schedule C or Sole Proprietorship is one option. A second option is operating as a LLC or Limited Liability Corporation. A third option is incorporating and operating as a C Corporation. A fourth option is incorporating and operating as a Sub Chapter S Corporation. This week, we will look at that fourth option.
All Sub S Corporations file a Federal Form 1120S, upon which is reported the income and expenses of the business. Each of the shareholders of the Sub S Corporation receives a K-1. On the K-1 is reported the shareholder’s share of the profit or the loss of the corporation as well as items that are separately stated to the shareholders.
An example of a separately stated expense item is the expense deduction should the corporation elect to completely write off the purchase of an asset. An example of a separately stated income item is the capital gain that may result from the sale of an asset. The profit or loss of the business and the separately stated items is divided by the ownership percentage of each shareholder. When the shareholders file their personal Form 1040, each of the items on the K-1 is reported as an income or expense item.
In only extreme circumstances would the Sub S itself pay any tax. The shareholders pay the tax at their personal tax rates.
One of the largest differences between a C Corporation and a Sub S Corporation is that the C Corporation pays tax on its profit while the shareholders pay tax on the profit of a Sub S Corporation.
A further difference is the shareholders of the Sub S are then eligible to receive distributions of their share of the profit that is taxed to them. As opposed to a partnership or a Sole Proprietorship, this profit is not subject to Social Security tax. Since they have paid tax on the profit, these distributions are not considered additional taxable income. It bears repeating that these distributions and the allocated profits are not subject to Social Security tax.
However, shareholder employees of the Sub S must receive wages. These wages are reported on a W-2. Shareholder employees must be paid a reasonable compensation for their efforts. It is against the rules for a shareholder employee to not receive a paycheck. A Sub S cannot be used to convert earnings that would be subject to Social Security tax away from Social Security tax.
For example, Taxpayer A’s business is a Schedule C with a profit of $50,000. Taxpayer A pays regular income tax on the $50,000 as well as Social Security tax of approximately $7,065. Taxpayer A subsequently incorporates his Schedule C to an 1120S. The 1120S still has profit of $50,000 that is allocated to the shareholder, Taxpayer A, on a K-1. Taxpayer A would owe regular income tax on the $50,000, but because the profit came from a Sub S, there would be no Social Security tax computed and due. The result would be a tax savings of $7,065 to Taxpayer A. This tactic is totally against the rules. Taxpayer A must be paid a reasonable compensation for the work he does for his Sub S. The reasonable compensation is subject to Social Security tax just like anyone’s wages is subject to Social Security tax.
Unfortunately, there is no black and white answer as to what constitutes reasonable compensation. Let’s just say that zero compensation is unreasonable. In addition to the requirement of receiving a paycheck, more than two percent shareholder employees of Sub S Corporations are bound by some further special rules as regards fringe benefits.
The most common fringe benefit to discuss is health insurance. A two-percent shareholder employee can receive health insurance through the Sub S. However, the current rules state that the health insurance premiums are to be included in the compensation package and, therefore, the W-2 of the two-percent shareholder employee.
A separate reason, other than the compensation issues, to form a Sub S is that corporations can be used to limit the personal liability of the shareholders. Similar to Limited Liability Corporations (LLCs), Sub S Corporations create a separate entity that encapsulates the liability of the shareholders within that entity. In reality, this limited liability issue may be one of the main reasons that a business owner may decide to incorporate the business.
Prior to LLCs coming of age in the last 10 years or so, forming a corporation was about the only way to limit liability. Now forming a LLC is a legitimate option. It’s best to consult with an attorney and a tax professional before deciding which form of business entity to choose. Each business entity has pros and cons. Hearing those pros and cons from more than one source will help in the decision-making process. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. He owns
Action Tax Service on Northland Drive in Rockford.
His telephone number is (616) 866-4704, and
e-mail address is firstname.lastname@example.org.