My last blog post might have raised a couple of issues with some folks who are looking at choosing between a “C” Corporation or an “S” Corporation. Let me add some details here. Corporations come in two basic flavors. The default is a “C” Corp. However, you can also make an “S” election. “C” and “S” refer to Internal Revenue Code Subchapters dealing with income tax treatment. C and S Corps differ primarily in how income tax liability is assessed.
C Corps are separate taxable entities with their own tax rates and returns. S Corps pass through corporate income and deductions to owners’ individual income tax returns.
S Election Benefits vs. a C Corporation
Depending on your circumstances, an S Corp may be more tax-efficient. You may lower your income taxes and be able to sell the business in a more tax-efficient way.
C Corps pay their own taxes on any corporate income. Taxable distributions (dividends) are then made to owners. This creates a potentially costly “double tax” trap. Owners of S Corps avoid this trap. They can also potentially reduce their Social Security and Medicare taxes.
When a C Corp is sold, the corporation is taxed on the sale gain. The remaining proceeds become a taxable distribution to owners. This can consume much of the value of the business in taxes. By contrast, S Corps can structure a business sale with a much lower tax burden.
S Corporation Restrictions
Business owners who elect S Corp status accept some restrictions in how they own and operate their corporation:
- No more than 100 shareholders;
- Must be a domestic corporation;
- Limited to one class of stock;
- Cannot have any nonresident alien shareholders;
- Must not be a bank, insurance company, or domestic international sales corporation (DISC);
- Only allowable shareholders are individuals, estates, exempt organizations described in I.R.C. §401(a) or §501(c)(3), or certain trusts described in §1361(c)(2)(A).
Maintaining compliance with S Corp status is important. The IRS can disallow your S election and charge heavy tax penalties if you violate S rules.
Restrictions for Owners of 2%+ of Stock
Certain S Corp restrictions apply only to shareholder-employees with 2%+ ownership. These individuals have tax deductibility limits on treatment of fringe benefits. Violating these limitations can create IRS trouble for business owners. For 2%+ owner/employees, fringe benefits are included as taxable wages. While deductible to the S Corp, they increase the owner’s taxable income.
The fringe benefit rules only apply to “statutory fringe benefits”, not to stock options, qualified retirement plans, and nonqualified deferred compensation. Fringe benefits reported as wages under the >2%-owner rule include:
- Group term life insurance premiums
- Accident and health benefit plan insurance premiums
- Meals and lodging furnished by the employer
Other fringe benefits, like compensation for injuries, sickness, and dependent care assistance, aren’t considered wages. Note also that 2%+ shareholders usually can still deduct statutory fringe benefits using sole proprietorship rules. Check with your CPA for more information.
One of the most common S Corp pitfalls is when owners try to transfer shares of the S Corp into trusts or partnerships not allowed under S Corp restrictions. They also frequently see violations of tax deductibility rules. If you have made an S election for your corporation, you need to follow the rules that accompany this particular business form. You should also benefit from all the distinctive benefits of your S election.
Since a C Corp is the default corporate form, many businesses end up using it without considering whether it is best for their circumstances. If you are operating as a C Corp, Bulletproof Veil can walk you through an analysis to see whether making an S election is right for you. Regardless of which business form you choose, Bulletproof Veil can help you get the greatest benefit from it. Why not call them at 1-888-716-3180 and take advantage of their free 15-minute consultation to learn more about whether a “C” corp or an “S” corp is best for you?
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