There are few things in the tax world that have as much misunderstanding and misinformation than S Corporations. S Corporations can help small businesses achieve various goals but only if set up and administered correctly with a good understanding of the tax law. Below are 5 things every S Corporation owner should know, and should have known prior to being taxed as an S Corporation.
- S Corporations are a tax fiction: S Corporations aren’t technically a legal business structure. Rather, they are a tax fiction. You elect to be taxed as an S Corporation by filing Form 2553 with the IRS. In other words, if your LLC business makes an S Corporation election for tax purposes you still have an LLC. Having said that you still have to follow the tax fiction through to its conclusion when making certain decisions like liquidating the company or selling the company in a transaction. One might then ask, what happens prior to making the S Corporation election? LLC owner’s that don’t make an S Corporation election are by default taxed either as a sole proprietor (single owned) or a partnership (multi-member owned). There is no “LLC” tax return, per se. Incorporated businesses that don’t make the S Corporation election are by default taxed as C Corporations. However, your legal entity does impact the pros and cons and benefits and risks of making an S Corporation election. Generally, LLC’s and Inc’s are allowed to make the election to be taxed as S Corporations, with each having their own special issues that arise due to the cross-section between the type of legal entity and type of tax entity.
- Reasonable compensation requirement: The IRS requires that active shareholders of S Corporations must pay themselves a reasonable compensation before taking tax-free distributions out of the company. Generally, this has been left up to the tax courts to determine what is a reasonable salary (see McAlary vs Commissioner and David Watson, PC vs USA). These court cases have determined that there are 3 general approaches to determining a reasonable salary: the cost approach, the income approach, or the market approach. The most common – and generally best approach for small businesses – is the cost approach whereby reasonable salary is determined by calculating the replacement cost of services using factors such as the tasks performed, time on average to perform those tasks, and proficiency at those tasks. Without one of these methods calculated and documented appropriately, the IRS has the authority to reclassify S corporation distribution payments as wage payments subject to employment taxes (Sec. 7436; Rev. Rul. 74-44). This would generally include penalties and interest if reclassified.
- S Corporations do not have to make equal distributions: In likely the biggest misconception around S Corporations, what matters most to protect the S Corporation’s tax status is that the S Corporation’s governing documents (e.g. operating agreement) contain language that “confer identical rights to distribution and liquidation proceeds.” Voting rights are ignored so it is possible for S Corporations to have both voting and nonvoting stock. It is then allowable to have years in which the S Corporation makes unequal distributions to its shareholders and maintain its S Corporation status so long as its governing provisions confer equal rights to the distributions and that the distributions ultimately get trued up in a future year. In certain IRS Private Letter Rulings, they have determined that even 3 consecutive years of unequal distributions followed by a true up distribution in year 4 was completely valid because the governing documents conferred equal rights. To summarize, what matters most is what the company’s governing documents actually say about distributions (that they confer identical rights) rather than what the S Corporation actually distributes to its owners.
- Review and update your operating agreement: To build upon point #3 above, every S Corporation owner should review their operating agreement to ensure that no partnership related provisions are contained in them. Often times when a company is first forming and an operating agreement is drafted, attorneys will use standard partnership language in the operating agreements – and rightfully so – since (as noted above) multi-member LLC’s are by default taxed as partnerships. The attorney likely didn’t know that you planned on making a future S Corporation election. Any references to substantial economic effects, partnership capital accounts, etc should signify that the person who drafted the agreement was drafting it under the presumption that the company was going to be taxed as a partnership instead of an S Corporation. This would typically be viewed as creating a second class of stock and therefore tainting the S Corporation’s tax status.
- Self-employment tax savings: Some S Corporation owners may understand that they are saving tax by being an S Corporation but don’t really understand why or how. S Corporation owner’s should first generally understand that self-employment tax is essentially payroll tax. Recall the default tax treatments for LLCs above (either partnerships or sole proprietors). As an active partner of a partnership or a sole proprietor, you pay self-employment tax on your share of the company’s net taxable income. That self-employment tax rate is 15.3%. How is that tax rate determined? Most employees are familiar with payroll taxes being withheld from their paychecks such as Medicare tax (1.45%) and Social Security tax (6.2%). What they likely don’t know is that their employer pays another 1.45% Medicare tax and 6.2% Social Security tax on the same wages. In other words, the employee pays half and the employer pays half. Combine the 2 and you get 15.3% (7.65% * 2). When an S Corporation election is made, instead of paying self-employment tax on the company’s entire net taxable income, you are only required to pay payroll tax on your reasonable compensation. For example, a 100% owned LLC with no S Corporation election has net taxable income of $100,000. They would otherwise owe $15,300 of self-employment tax[1]. Assume that same company the same year made the S Corporation election instead and determined that the 100% owner’s reasonable compensation was $50,000. Instead of owing $15,300 in self-employment taxes, they owe $7,650 in payroll taxes for a tax savings of $7,650. This is a generalization and in fact, there would be other payroll taxes and costs associated with making the S Corporation election. The true tax savings need to outweigh those additional costs and align with the goals of the company, both short and long term, before deciding to make the S Corporation election.
As the max social security tax base continues to rise ($160,200 for 2023), S Corporation’s will continue to be valuable tax planning options for small businesses. It is therefore important for S Corporation owners to understand the basics of how S Corporations work, where the tax savings are coming from, and whether their S Corporation tax status is in jeopardy.
Give us a call or email today to discuss your S Corporation and how we can help with tax planning for your small business.
[1] Note that the calculation doesn’t actually work out this way. This is just for illustrative purposes and to keep it simple it’s assumed that the 15.3% would apply to the entire net taxable income of the business.