ADVANTAGES OF SMALL BUSINESS CORPORATIONS (S-CORP.)
The only intention of this page is to show the tax benefits of incorporating as an S-Corp. This page is not intended to induce any prospective client into forming a corporation for tax avoidance. Nevertheless, the Supreme Court of the United States has held that as long as a corporation has a legitimate business activity, the Court will not look to the reason for its creation:
“Whether the purpose [of forming a corporation] 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)
Whether a corporation, 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.
The S-Corp. does have greater tax advantages and savings to its stockholders 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) liability and by reducing the social security (FICA) and employment (FUTA) tax liability to the salary portion of the total income received by the stockholder.
This Memorandum will compare the following scenarios:
Unincorporated Business S Corporation Stockholder
$100,000Gross Income $100.000Gross Inc. of Corp.
-30,000Salary of Stockholder
$50,000 Adjusted Gross Income 20,000Adjusted Net Profit of Corporation
X 15.3%½ SE Tax Rate X15.3% FICA tax paid (15.3% of Federal)
-7,650 SE Tax -4,590FICA Tax
50,000 Total Taxable Income 50,000Total Taxable Income
11,680 Income Tax 11,680Income Tax
$19,330 TOTAL TAX $16,180TOTAL TAX
$3,150 Tax Savings
For purposes of argument, the unincorporated business taxpayer is self-employed, unmarried and filing separately. The S-Corp. 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. 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.
Adjustments to a Stockholder’s Basis in his S-Corp. Stock Ownership: Notwithstanding the above, one should note that a risk of tax consequences exists due to modifications in a stockholder’s basis of his stock ownership in the S-Corp. If an S-Corp. distributes cash or other property, the distribution itself is not taxed if the amount is less than the stockholder’s adjusted basis of his stock. If the amount of the distribution exceeds the adjusted basis of his stock ownership in the S-Corp., then upon such event the excess becomes “gain from the sale or exchange of property” and is inclinable in his gross income as capital gains.
Example 1: Assume for the current year that the S-Corp. has no income or loss, and distributes $20,000 in cash. The sole stockholder’s stock ownership basis is $15,000.
Result: The $20,000 payout exceeds the stock basis by $5,000. The first $15,000 is not taxed and the excess $5,000 is a taxable capital gain to the stockholder.
A stockholder’s basis for his stock fluctuates according to the amount of corporate income/loss and distributions in and from the S-Corp. Corporate net income for the year increases his basis while the corporate distributions for the year decrease his basis.
Example 2: Mr. Long is a 50% stockholder in an S-Corp. The basis of his stock ownership is $20,000. The corporation’s net income for the year is $50,000 and $20,000 is distributed to Long.
Result: Long’s $25,000 share of the corporation’s income (50% of $50,000) increases the basis of his stock ownership to $45,000 ($20,000 basis + $25,000 share of corporate income.) Subsequently, the $20,000 S-Corp. distribution reduces the basis in his stock to $25,000 ($45,000 – $20,000). In addition, Long pays tax on the $25,000 corporate profit but does not pay tax on the $20,000 distribution because it is less than the adjusted basis of his stock ($20,000 – $45,000).
Therefore, if the stockholder maintains a large enough adjusted basis for his stock ownership in the S-Corp., any distributions from the S-Corp. may not be taxable. This additional potential tax benefit can be maximized by proper investment and tax planning.
Comparison of the Major Business Entities:
Sole Proprietorship/Partnership Regular Corporation S Corporation
Liability Personal Liability- Personal Assets At RiskLimited Liability- Protects Personal AssetsLimited Liability- Protects Personal Assets
Continuity of EntityLimited-
Termination Upon Death of PrincipalPerpetual-Survives Death of PrincipalPerpetual-Survives Death of Principal
Transfer of InterestRestrictedFree Transfer Unless Restricted by AgreementFree Transfer Unless Restricted by Agreement
Taxation of IncomeDirectly to PartnersDouble TaxationNo Corporate Tax, No Double Tax, Reduces FICA Taxation
Major Advantage(s)Simple, Low Cost at Start Up; But Large “Costs” in Risks and ExposureLimited LiabilityLimited Liability; No Double Taxation; Reduces FICA Taxation
Major Drawback(s)Unlimited Liability; Personal Assets at Risk; Restricted Transfer; Limited DurationGreater Start Up Cost; Double Taxation of IncomeNot Every Corporation Qualifies for S Status; Alternative solution: Limited Liability Company