Every corporation is, by default, taxed under Subchapter “C” of the U.S. Tax Code. However, taxation under Subchapter “C” requires the corporate entity to pay corporate income tax on net income at the entity level and then again imposes a tax on that income when distributed to its shareholders, as personal income to its shareholders. However, by electing to be taxed under Subchapter “S” of the U.S. Tax Code, most business are able to eliminate double taxation on distributions to shareholders under Subchapter “C” by eliminating the tax on income on the entity level.
Under Subchapter “S” there is no income tax on profits at the entity level. Rather, profits and losses of the corporation are “passed through” directly to the shareholders, much in the same manner as a partnership income passes through to the individual partners.; Thus, under Subchapter “S” there is only a single level of taxation on corporate profits, the shareholder level, with corporate profits being taxed to each shareholder according to his or her individual income tax rates.
Insofar as a single member limited liability company is by default taxed as a disregarded entity (a sole proprietorship) and insofar as a multiple member limited liability company is by default taxed under Subchapter “K” (a partnership), both of which already have only a single level of taxation, LLCs are generally less concerned with avoiding double taxation on distributions of profits under Subchapter “C,” than are corporations
However, under certain circumstances, even a limited liability company may wish to consider electing tax treatment under Subchapter “S.” This is particularly the case when doing so may legitimately help to reduce social security taxes and Medicare taxes otherwise imposed on the Members providing personal services to the company, just as might shareholders of a corporation who provide personal services to the corporation also reduce social security and Medicate taxes in limited circumstances. However, one must be cautious in doing so in either case, because such a method for reducing social security taxes and Medicare taxes is commonly abused. Only under certain specific circumstances can corporations (whether standard, professional, or statutory close corporations) or LLCs elect to be taxed under Subchapter “S.” And then only under still other limited circumstances should shareholders or members attempt to reduce their social security taxes or Medicare taxes under Subchapter “S.”
To obtain Subchapter “S” status under the federal income tax law all of the following requirements must be met: the entity must be a domestic corporation or LLC. The entity may not have more than one class of stock, though voting rights may vary. The entity may not have more than 100 shareholders or members. The entity may not have any shareholder or member that is a nonresident alien or nonhuman entity (such as other corporations or partnerships), unless the shareholder is Subchapter “S” parent that elects Qualified Subchapter “S” Subsidiary (“QSSS”) treatment for its 100.0% owned subsidiary (for federal tax purposes, a QSSS is not treated as a separate entity, but rather all the subsidiary’s assets, liabilities, and items of income, deductions and credits are treated as those of the Subchapter “S” parent [IRC Section 1361(b) (3) (A)] or an estate or trust that is authorized to be a Subchapter “S” shareholder or member under tax laws. Certain exempt organizations, such as qualified pension, profit-sharing, and stock bonus plans, or charitable organizations will be allowed to be shareholders in a Subchapter “S” entity (for purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt shareholder counts as one shareholder). In addition, a Subchapter “S” entity must operate on a calendar year basis ending December 31st unless there is a business reason not to do so.
To elect Subchapter “S” taxation as a corporation you must file IRS Form 2553 with the IRS. To elect Subchapter “S” taxation as a limited liability company, you must file IRS Form 8832 and IRS Form 2553 (though temporary Treasury Department Regulations currently require that only IRS Form 2553 be filed with the IRS). The LLC must also file an Initial Annual Corporate Report Form CL-1 with the South Carolina Department of Revenue if it has not previously done so.
One important difference between partnership and Subchapter “S” taxation is that under Subchapter “S” all profits, losses, and other items that pass through to the shareholders or members must be allocated according to each shareholder's or member’s proportionate shares of stock or membership rights which must represent uniform financial rights such as does common stock. For example, if you own 50.0% of the stock in a corporation you must receive 50.0% of the losses, profits, credits, etc. You also have 50.0% of the voting rights in shareholder matters. With a general partnership or an LLC taxed as a partnership under Subchapter “K” of the U.S. Tax Code, the partner or member can receive different percentages (or changing percentages over time) of different tax items, or even disproportionate voting rights, if the operating agreement so specifies. For example, a member who had contributed most of the capital or property to the company can have 50.0% of the profit and 100.0% of any loss allocated to him, but receive only 25.0% of the voting rights in the company. When an LLC does have such different percentages (or changing percentages over time) of different tax items, such differences would likely disqualify the entity for Subchapter “S” election insofar such rights vary too greatly from the requirement that every entity taxed under Subchapter “S” have common-shares.
Another important difference is that a member of an LLC taxed as a sole proprietorship (disregarded entity) or partnership is generally considered “self-employed” and not an employee. He or she, therefore, is not obligated to pay themselves a regular salary or wage. Moreover, he or she is also not subject to the additional administrative burden of withholding income tax or payroll taxes from each of his or her distributions of profit. Nor are they required to pay federal or state employment security taxes on his or her distributions. Self-employed individuals also do not count as employees for the purpose of meeting the worker’s compensation requirement threshold (generally four or more employees within twelve months) or application of the South Carolina Wage Payment Act threshold (generally five or more). Instead, self-employed individuals are required to pay income taxes and self-employment taxes (social security and Medicare) on a quarterly estimated basis. In contrast, shareholders or members who provide personal services to an entity taxed under Subchapter “S” in exchange for compensation are considered employees with respect to such services, not unlike any other employee, and are therefore subject to the same withholding tax, payroll tax, federal and state employment security taxes, and are included in employee count thresholds for worker’s compensation coverage and the South Carolina Wage Payment Act.
Shareholders or members who provide personal services to an entity taxed under Subchapter “S” may, however, in certain limited instances enjoy a reduction in social security and Medicare taxes when compared to business taxed as a sole proprietorship or partnership. For example, if a shareholder-employee receives a distribution from the Subchapter “S” corporation, no payroll taxes are taxable on such a distribution. Rather, the income is taxed to the shareholder as personal income from a return on his or her investment. But it is not subject to social security taxes or Medicare taxes.
So why should a shareholder or member who provides personal services to an entity taxed under Subchapter “S” take a salary at all? Because the IRS requires that each such shareholder or member receive a “reasonable” salary or wage. What is meant by “reasonable” is generally what such a shareholder or member might receive as a salary or wage if he or she was providing similar services to a third party employer, though other factors might also be included.How much salary should a shareholder-employee take? That depends entirely on the circumstances and should be determined only in consultation with a competent tax advisor.If the shareholder or member does significant work for the corporation or LLC and reports little or no salary, he or she is asking for trouble. If the shareholder or member has a service company with no other employees, it is a fairly difficult argument to make that all profit is not directly attributable to his or her personal services and therefore compensation that should be subject to payroll taxes. Possible exceptions might include instances where the corporation or LLC profits from other employees, has significant goodwill or investments in capital equipment, is inactive, or where the activities of the business do not require substantial work—for example, an entity whose only business activity is to hold title to real estate that is rented to another business may be able to justify not receiving a salary.
Some additional factors that might justify a low salary:
However, it should be noted that a reduction in any payroll taxes depends on the difference between what is reasonable compensation and what is actually earned. The closer the company’s earnings and one’s reasonable salary or wage, the less the reduction in payroll taxes there will be. And even this differential has limits insofar as social security (the bulk of the payroll taxes) is not paid on income earned above an annual threshold amount. The actual reduction in payroll tax therefore may not be substantial. The additional administrative burdens and costs to a business taxed under Subchapter “S,” including the need for filing a separate corporate tax or informational return and the need for withholding income and payroll taxes from each payment of compensation to the shareholder-employee or member-employee might outweigh possible advantages.
Although it does not pay federal or state income taxes, an entity taxed under Subchapter “S” must file a Federal return on Form 1120S, U.S. Income Tax Return for an S Corporation and a South Carolina state return on Form SC-1120S. These forms show the results of the corporation’s operations for its tax year and the items of income, gains, losses, deduction, or credits that affect the shareholders or members individual income tax returns. The proportion of each of these tax items is based on the proportion of shares held by each shareholder or member.
Similar to with a partnership, shareholders or members in an entity taxed under Subchapter “S” each receive a copy of Schedule K-1 from the corporation or company showing the share of income, credits, and deductions of the business for the tax year allocated to each shareholder or member.
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