S-Corporations: What are they and why care? - Part 2

Part 2: Saving on Employment Taxes? How?

1. Introduction.

As described in the previous post, an "S-Corporation" is a unique tax designation created by the IRS that is neither a corporate tax status, nor a partnership tax designation. It is designated as a "Small Business Election" by the IRS. Under the IRS's check the box regulations, any qualified business entity can be designated as an S-Corporation by the IRS, be it a partnership, corporation, LLC, or sole proprietor. To form an S-Corporation, the business entity, files a form 2553 with the IRS asking for the designation and will receive a reply letter acknowledging its acceptance. Not every business entity may become an S-Corporation. All members of the business entity must be U.S. residents or citizens, natural persons, and there can be no more than one hundred (100) owners of one class of stock. Below, I will further describe some of the advantages and restrictions on S-Corporations.

2. Saving Money on Payroll Taxes: Dividends are Not Payroll.

Closely held C-corporations often distribute substantial salaries to the owners, and avoid double taxation on corporate earnings by insuring that salary deductions match remaining unspent income to the corporation. In constrast S-corporations shareholders may be paid salaries but any remaining amounts of S-corporation income are taxed to them at ordinary individual rates without any payroll taxes deducted.

In order to appreciate the significance of this tax savings, it is important to understand how much payroll taxes cost the owner of a business on his own salaried income. Under the IRS Code, Social Security and Medicare (FICA) taxes are assessed on both the employer and the employee at the rate of 7.65% of wages paid to the employee during the year (15.3% total). The FICA tax consists of Social Security tax at the rate of 12.4% on the first $XX of wages paid (increase each year) with 6.2% paid by the employer and 6.2% paid by the employee. Also, the hospital insurance (Medicare) tax is assessed at the rate of 2.9% on all wages paid to the employee during the year, with 1.45% paid by the employer and 1.45% paid by the employee. There is no wage base cap on the Medicare portion of the FICA tax. By example, on $100,000.00 of income, the typical owner-employee would pay $15,300.00 in payroll taxes, both employer and employee shares. The S-corporation employee-owner avoids this by paying only "reasonable compensation" as salary and the remainder as dividends.

3. Asset Protection Issues.

Asset protection is important to professionals and high-wealth individuals as well as ordinary individual business owners with good credit and a desire to avoid debt collectors. Often the regular business owner is asked to guaranty a loan or other form of indebtedness. If the purpose for the loan or the overall business enterprise is unsuccessful, the individual owner may become liable to the maker of the promisssory note. Under these circumstances, the business owner looks to his business attorney to best advise him on these issues and which business entity best protects him and his business. If the business owner has personally guaranteed a debt, his personal assets are at risk. With regard to his ownership in the business enterprise itself, the business owners' assets are best protected by the LLC, rather than a corporation, partnership or sole proprietorship. This is because his debtors cannot attach or have ownership in the LLC, but instead may obtain only a charging order instead. The creditor cannot obtain distributions from the LLC and the debt will likely remain unpaid. In contrast, the debtor can obtain the stock of the debtor's ownership in any corporations, and can force dividends to be paid to shareholders. This is also true of sole proprietorships.

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