Incorporation is one of our specialties, and many of our clients come to us because they want to incorporate their business. After all, incorporation helps protect you in the event of a lawsuit, and forming a separate business entity helps separate the company’s debts from your private assets. However, our customers also often ask us about a real caveat to incorporation – double taxation. After you incorporate, your business has to pay a tax on any income that it earns, subject to the federal and state corporate income tax rates. On top of that, you still have to pay tax on income you earn from working for the corporation. Effectively, this taxes the same amount of income twice, and that heavy burden frightens many small business owners, most of whom don’t have much extra capital to throw around. There is, happily, a way to avoid double taxation, and it is the subject of our Business Basics post for this week – filing for S-Corporation status.
Chapter 1, Subchapter S of the Internal Revenue Code allows smaller businesses to avoid paying federal, and usually state, corporate income tax. S-Corporations are the most popular type of corporation in the United States, with 61.9% of all active corporations filing Form 1120S to apply for S-Corp status.
In order to qualify, your corporation must have fewer than 100 shareholders and issue only one class of stock. If your corporation qualifies, you can file for S-Corp status, which will allow any income earned by the corporation to pass through the business, untaxed, directly to the shareholders. You, of course, still have to pay your personal income taxes, and by law must take a reasonable compensation as a wage. But your corporate income, in most cases, will stay untouched.
This pass-through structure, however, is only guaranteed at the federal level. You should also check with your state’s secretary or department of corporations to see whether or not the state respects the pass-through structure of an S-Corp. Most states do, but some still require some tax to be paid on corporate income. California, for example, levies a 1.5% income tax on anything earned by S-Corps in the state.
If you decide to elect S-Corp status, you must file Form 1120S by the 15th day of the third month of the tax year, or the government will tax your business as a standard C-Corporation. In addition to this, you have to adhere to all of the other regulations that you would with a standard C-Corp – that means holding shareholder meetings, board meetings, and filing an annual report.
S-Corporations are the perfect fit for those small businesses that are looking to raise money through selling a limited number of shares, but don’t want to pay income tax twice. The IRS has a handy site that lists all of the necessary forms and deadlines.
And, of course, if you have any questions about Corporations or S-Corporation elections, feel free to leave them in the comments below, or give us a call at 1 (877) 692-6772 – we’re happy to answer any questions you might have!