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Appreciating the S Corporation

The sub-chapter S Corporation (or S Corp) is structurally the same as a C corporation (i.e., it has officers, directors and shareholders), but with one key difference...

Written By: Garrett Sutton
The sub-chapter S Corporation (or S Corp) is structurally the same as a C corporation (i.e., it has officers, directors and shareholders), but with one key difference. An S Corp files an election with the IRS, called a Form 2553, that provides it with a flow-through tax structure as found in entities such as partnerships and limited liability companies. That means, the company's income (and corresponding expenses, write-offs and deductions) will flow through to its shareholders, and be split among them according to each shareholder's ownership percentage. The S Corp's taxes will actually be paid by its shareholders, at their individual tax rates, and in proportion to their individual ownership percentages.

From a taxation standpoint, an S Corp is a great fit for a company that offers a service, because in many cases the revenues can be split and paid to the shareholders in two categories: salary and distribution (or profits) earnings. A flow-through tax structure means that the profits and corresponding losses, deductions and expenses are divided up among the shareholders, in proportion to their ownership percentages, and reported on each shareholder's personal income tax return. Therefore, if your income from an S Corp is split into two streams, salary and profits, each stream will be taxed differently. Your salary stream will be subject to both income tax and payroll taxes which amount to a whopping 15.3% for Social Security and Medicare. However, the profit income stream will be subject only to income tax. So, by taking a reasonable salary from the S Corp and the rest in profits your taxes will be lower than if you were take your entire share of the earnings as salary. By allowing a percentage to flow through to you as profits you can save thousands of dollars a year in payroll taxes which, as we all know, we will never see the benefit from since Social Security is broken and bankrupt.

An S Corp is also a great entity for businesses with low start-up costs that do not have to purchase a significant amount of assets to begin operations. For example, buying a working laundromat would be an excellent choice for an S Corp. You are purchasing a turnkey business - it's already operating, and you aren't going to be laying out significant cash to get it up and running. So, you will have a pretty good income stream immediately, and that income stream can best be disbursed to you and your partners, if any, through the S Corp structure. Two other great matches for an S Corp are network-marketing and Internet-only businesses. In each case, the business is likely to have no storefront, low operating costs, and probably doesn't maintain a warehouse. Most network marketing and Internet-only businesses drop-ship from their suppliers directly to the end consumer when they are delivering products at all. Again, as these can be high-income, low cost operations, they work great in the S Corp structure.

Here's another reason we suggest S Corps for many service-oriented businesses: To avoid being characterized as a Personal Service Corporation, or "PSC" by the IRS. PSCs are C corporations that are classified by the IRS as providing a service, such as consulting, to the general public. Now, as you may know, the United States government, in an effort to boost the economy and keep business working, assesses C corporations with a pretty low initial rate - 15% on earnings up to $50,000. That's quite a bit lower than you would pay personally, if you were receiving that same $50,000 as salary. And that 15% rate is also lower than you would pay if your business was an S Corp. So, to head off the anticipated revenue drain, the IRS closed that loophole by designating C corporations that provide services to be PSCs. The additional tax rate for PSC earnings can be a flat 35% or the regular C Corporate rate plus 15% of the corporation’s undistributed personal holding company income. That may be higher than you would pay through your S Corp, if you took a reasonable salary and the rest as profit income. And, it's enough, in many cases, to make the difference between choosing an S Corp and C Corp. Next week we’ll look at one significant downside to the S Corporation.

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