A quick and simple introduction to understanding s corporation taxes for beginners.
Disclaimer: This is not tax advice. If you are considering an s corporation for your small business taxes, do your due diligence. Hire a tax professional and read the IRS instructions. This is just a quick introduction.
An s corporation is not a type of business entity.
An s corporation is not a way in which you set up your business. You don’t “form your business as an s corporation”. Instead, an s corporation is a set of tax rules that you “elect” for your business formation.
To get a good grasp on this, let’s look at some common business setups:
- If you start a business under your own name and social security number, and you do not form an entity, this is generally called a sole proprietorship.
- Another common way to set up a business is to form an LLC. An LLC is its own entity and this gives you (and other members, if applicable) some separation from the business along with some liability and financial legal protection.
- One more very common business set up is a corporation. This is another legal entity formation that separates its shareholders from its owner(s).
Except for the sole proprietorship, these business formations (entities) are all set up at the state level. They are organized with the state. They follow state legal rules for financial and liability purposes.
But the way that the IRS sees them for federal income tax purposes is another story completely.
Default tax rules for different business formations
Generally (not always), if you did not form an entity, the IRS will see your business as a sole proprietor by default and your business will be subject to sole proprietor tax rules and filing requirements.
If you form an LLC for your business, and the LLC has only one member, then, by default, the IRS also sees your business as a sole proprietor. The IRS refers to this as a “disregarded entity”.
A disregarded entity sounds “rude”, but it actually allows singly owned small businesses to enjoy liability and financial legal protection at the state level, but also somewhat simple and inexpensive tax filing rules at the federal level. You can have your cake and it’s easy to eat, too.
A multi-member LLC, however, generally defaults to being taxed under “partnership” tax rules by the IRS.
A corporation defaults to being taxed under traditional tax rules, which is also known as a “c corporation”.
An S Corporation is an alternative “election” of tax rules for your business entity.
If an LLC or a corporation meets certain criteria, they can elect for the IRS to “see them as an s corporation” for federal income tax purposes instead of receiving tax treatment under the default tax rules.
This allows your business to be taxed as an s corporation, but still keep it’s legal formation characteristics at the state level.
Get it? An s corporation is just a way that the IRS “sees” your business, if you elect it to be so.
What are s corporation tax rules?
The answer is that, generally, an s corporation is similar to a traditional corporation, except that it has “pass through” rules such as a partnership or a sole proprietorship.
With a traditional, or “c” corporation, income is taxed first at the corporate level. The profits do not pass through to the shareholders. Then the shareholders are also taxed on any dividends or distribution of profits.
This is double taxation, and it kind of stinks.
Because of this unfavorable tax treatment, a c corporation is seldom a great set of rules for a small business to choose to be taxed.
There are exceptions to this, so don’t hold me to that, but unless your small business has some sort of structural or other specific administrative need, c corps are kind of lousy, actually.
For the most part, if c corporation taxation can be avoided, it makes sense to do so (again, not always).
An s corporation is a pass through entity
In comparison to traditional, or “c” corporation taxation rules, an s corporation (generally) does not pay income tax at the federal level. Instead, the net profit passes through to its shareholders and tax is applied at the individual level.
So instead of being taxed twice, once at the corporation level and then once again at the shareholder level, s corporation rules skip the first part and send the net profit directly to the shareholders.
Taxed once. Much better.
This seems almost too good to be true, right? Why would the IRS allow such a thing in comparison?
Well, there’s more to it than just that. first of all, sole proprietorships and partnerships also receive passthrough tax treatment. Also, s corporations have a lot of tax compliance requirements, which can be expensive. So even though at first glance the rules for an s corporation sound tremendously better than a c corporation, making the s corp election is not the “end all, be all” when it comes to figuring out the best set of tax rules for your business.
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