By Roman Basi It’s tax season. And that means taxpayers and business owners want to pay as little money to the federal government as possible. Tax deductions, tax credits and other means of reducing your tax burden are good throughout the year. But when was the last time you evaluated the taxation structure of your entity?
While some small businesses fall under sole proprietors (where income is reported on an individual’s Schedule C) or partnerships (where income is reported on a business’ Form 1065), others may prove to be more beneficial to elect either S corporation or C corporation status with the Internal Revenue Service in an effort to minimize their tax burden.
S corporations are entities that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only “allowable” shareholders (may be individuals, certain trusts and estates, but not partnerships, corporations or non-resident alien shareholders)
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies and domestic international sales corporations)
- File a Form 2553 (Election by a Small Business Corporation)
Structure of a C corp
C corporations operate quite differently. In forming a corporation, prospective shareholders exchange money or property (or both) for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. All C corps pay a flat 21% tax rate on net business income.
The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
While C corporation profits are taxed twice, since the 2017 Tax Cuts and Jobs Act was signed into law, C corporation taxes are a flat 21%. Individual federal income tax rates can go as high as 37%. Another change with the 2017 tax law is that owners of pass-through entities like S corporations may be able to deduct 20% of the business income from their individual tax returns. C corporation owners are not afforded that luxury. If an individual’s personal tax rate is greater than 21%, it may be worthwhile to consider converting to a C corporation.
If you own a small business and have any questions regarding tax structure, reach out to The Center for Financial, Legal and Tax Planning at 618. 997. 3436.
Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-authored the article with Michael Hampleman, associate attorney. For more information, please visit taxplanning.com.