Business Law 101 / Subchapter S Formed To Save Taxes
The Subchapter S Corporation (also referred to as an S-Corporation) is derived from Section 1244 of the Internal Revenue Code. S-Corporations are formed to save taxes. How does this happen? By bypassing the corporate tax.
Under general tax rules, when a company makes a profit, it is taxed on that profit. The remaining profit is then often distributed to the shareholders as a dividend. The shareholders are then taxed on the dividend. This means that the IRS has taxed the profits of the corporation twice and, in states with a state income tax, this may amount to nearly 70 percent of the profits. Because this is very onerous to small businesses, the Internal Revenue Code created the Subchapter S provision that benefits small businesses.
With a Subchapter S corporation, the profits of the corporation are passed directly to the shareholders (as are the losses) so that the profits are only taxed on the individual level. Let’s give an example. Let’s say a corporation has a before tax profit of $10,000. Under general tax laws, using an estimated federal income tax of 25% and an individual rate of 20%, the corporation would pay $2,500 in federal income tax. The remaining $7,500 is then paid to the shareholders as a dividend. If we use an estimated tax rate of 20%, the shareholders pay $1,500. in individual tax on this dividend. This leaves a balance of only $6,000 of the original $10,000. In states outside of Florida that have a state income tax, this amount would be even lower.
However, if the corporation falls under the provisions of Subchapter S, the profits are passed directly to the shareholders. Therefore, the company would pay no income tax and the full $10,000 is passed directly to the shareholders. The shareholders then pay $2,000 tax on the dividend, leaving a balance of $8,000. By filing as a Subchapter-S corporation, the shareholders/corporation saved $2,000 (or 20%) in taxes.
Some business people believe they can avoid this tax by simply not paying dividends; however, general corporations (called C-corporations) are subject to an accumulated earnings tax if they amass more than $250,000 in retained earnings. Also, if the assets are sold, the shareholders will be taxed on the dissolution of the business.
There are many benefits to Subchapter S Corporations. First, corporate income tax is usually higher than individual income tax. Also, shareholders may be able to reduce taxes even more by shifting income to family members who may be in lower tax brackets. Another benefit arrives for shareholders that are also employees of the corporation. Salary income is subject to both income tax and social security tax; however, dividend income is subject only to income tax. Therefore, by taking a smaller salary and the balance as a dividend, the shareholder/employee can reduce the amount of social security tax they pay.
Another advantage to S-corporations occurs when the corporation has a loss. As with income, losses are passed directly to the shareholders. The shareholders can then use these losses to offset income in other areas.
There are certain requirements to forming a Subchapter S corporation. First, this election is only for small businesses, so there can be no more than 125 shareholders. Also, all shareholders must be either U.S. citizens or legal resident aliens. Finally, the company cannot derive a substantial portion of its income by investing in other businesses. Formation of a Subchapter S corporation requires the filing of an application (IRS Form 2553) which requires all shareholders to consent to the Subchapter S election. This application must be filed within 75 days of the first business activity, or by March 15 of any calendar year.
Al Kelley is a Florida business law attorney located in Key West and previously taught business law, personnel law and labor law at St. Leo University. This article is being offered as a public service and is not intended to provide specific legal advice. If you have any questions about legal issues, you should confer with a licensed Florida attorney.[livemarket market_name="KONK Life LiveMarket" limit=3 category=“” show_signup=0 show_more=0]