May 22/29, 2017: Volume 31, Issue 25
By Roman Basi
(Second of two parts)
In part one of this segment, I talked about the pros and cons of structuring your business as a limited liability company (LLC). In this section, I will discuss the differences between “S” and “C” corporations.
With an S corporation, profit is not subject to self-employment taxes. The self-employment tax is 15.3% for those who are self employed and encompasses both Medicare and social security taxes. Normally, when a person is employed by a company, the employer pays half of the tax subjecting the employee to only paying half of the full tax. When one is self employed, he or she must pay the full tax on their own. Under the use of a Subchapter S corporation, salary (not profit) is subject to self-employment tax. However, if the salary is insufficient, the IRS can reclassify the profits as a salary subjecting them to self-employment taxes.
This differs from LLCs, whereby both salary and profits are subject to self-employment taxes. For people with incomes below the social security threshold amount, this can result in a significant amount of money being put into self-employment taxes. This can be good or bad depending on one’s retirement planning needs and expectations.
Since S corporations are flow-through entities, losses can be deducted. This is also true for the LLC. However, this is in contrast to C corporations in which shareholders cannot deduct losses. Note: If an S corporation is experiencing losses, it can deduct them, and the owner will recognize the loss on his income statement, leading to a lower tax liability. However, there is a limit. You cannot deduct amounts that exceed your investment and loans to the company.
During operation of an S corporation, profits are taxed only at the shareholder level as opposed to C corporations, which are taxed twice. Just like with the LLC, the profits—not the distributions—are taxed.
When winding up the affairs of the entity and dissolving the business, profits are taxed once. This differs from C corporations, which can be hit very hard with taxes upon dissolution of the corporation.
Subchapter C corporation. Even though C corporations are taxed once at the corporate level and then at the shareholder level, certain tax advantages can come into play due to new tax legislation. Profits from a C corporation to a shareholder are known as dividends, not distributions. Dividends from C corporations enjoy a special tax rate at 15% to 23.8%. This means that money received from a C corporation, no matter if it is $1 or $1 million, every dollar is taxed at a maximum of 23.8% and is not subject to ordinary income tax rates, which can run as high as 43.4%.
At the corporate level, C corporations enjoy lower tax rates than most people do at many income levels. If your income is low enough, you may be able to use this to your tax advantage. If the corporations’ income is below $75,000, it can be to the advantage of the corporate holder to use a C corporation.
Another advantage of running a business as a C corporation is there are no ownership restrictions. Nearly any person in the entire world—United States citizen or not—can own the stock, and there is no restriction on the number of shareholders. Generally speaking, having a C corporation allows the businessperson to accumulate a large amount of profits, reinvest them, etc., and not have to pay taxes at a personal level.
When deciding which entity type to go with, remember to carefully consider the various tax and legal ramifications.