"Inconceivable!" (Why "S-Corp" does not mean what you think it means)

You may, like me, be a fan of the cult classic The Princess Bride. But, even if you are not, it's likely you have come across this oft-repeated line in the movie:

The joke is that each time this character makes the exclamation, the thing being discussed is actually very possible if not probable.

And it pays off later in the film with another character saying:

It's a funny part of the movie that takes some time to set up, but with a satisfying payoff.

"But, Scott, what does that have to do with S-Corps? Just get to the point already."

Many new (and experienced) business owners are very confused about S-Corps and what they are and are not.

It isn't really their fault; S-corp is really poorly named, and here is why:

An S-corporation is a tax status with the IRS, NOT a type of entity. LLCs and other entities can elect S-corp status as well.

So each time I ask someone what kind of entity they have, and they respond with "S-Corp," I have to clarify: "So do you have a corporation that has elected S-Corp status or do you have an LLC that has elected S-Corp status?"

9 times out of 10 I am greeted with a blank stare and a moment of silence.

"OK so what does S-corp mean then?"

As hinted above, an S-corp is a closely held (read: few owners) corporation or LLC that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.

In English: the company does not pay income taxes. Instead, the company's income (and losses, deductions, and credits) are divided among and passed through to the shareholders/members/owners. The shareholders then report the income, etc. on their personal tax returns.

"Why does that matter?"

The S-corp shareholders avoid the traditional double taxation that a C-corporation must pay, while still getting the liability protection and other benefits of the corporate/LLC structure they elected.

"What is double taxation?"

Under a traditional C-corp, if the company reported any profits, the company paid the corporate tax rate on those profits while they sit in the corporate bank accounts. Then, when it is time to distribute money to shareholders, the shareholders pay personal income tax on the distributions. (Double tax.)

For example:

C-Corp:

Rattigan, Inc., a (fictional) C-Corp reported a net profit of $100.00. Rattigan, Inc. must pay the IRS taxes on that $100, roughly 25%. So Rattigan, Inc. is left with $75 after taxes.

Rattigan, Inc. only has 1 shareholder, so it distributes that $75 to Mr. Scott Rattigan, an individual.

Mr. Scott Rattigan, the individual, reports this $75 on his personal income tax filings and pays the marginal tax rate on the $75. For simplicity, let's say the marginal tax rate is 33% so he is left with $50 after taxes.

S-Corp:

If Rattigan, Inc. had elected S-corp status, it would look like this:

Rattigan, Inc., an S-Corp makes a net profit of $100. It distributes $100 to Mr. Scott Rattigan as sole shareholder. Mr. Scott Rattigan reports this $100 on his personal income tax filings and pays the marginal tax rate on the $100. For simplicity, let's say the marginal tax rate is 33% so he is left with $67 after taxes.

If you use $100,000 as the example then it becomes even more clear that $67,000 in your account is much more preferable than $50,000.

"What's the difference between sole proprietorship LLC taxes and LLC taxed as S corp. taxes?"

For many small businesses, the main difference is in the way business owners pay Medicare and Social Security taxes—also known as "self employment taxes." Some LLC owners can save money on these taxes by choosing S corp. taxation.

If a Single-Member LLC Is Taxed as a Sole Proprietorship:

The LLC member reports business income and expenses on his or her personal income tax return and pays personal income tax on company profits. The member is considered self-employed and thus is responsible for paying Social Security and Medicare taxes on those profits.

(As of 2016, self-employed individuals pay a 12.4 percent Social Security tax on the first $118,500 of income, and a 2.9 percent Medicare tax on all income, with an additional 0.9 percent Medicare tax imposed on high earners. Employees are subject to these same taxes, but the employer pays half and the employee pays half.)

If a Single-Member LLC Is Taxed as an S Corporation:

The member can be considered an employee of the business. An owner-employee must be paid a reasonable salary. The LLC will report the salary as a business expense, and the owner will report both the salary and any remaining business profit on his or her personal tax return.

However, unlike the sole proprietor LLC owner who must pay Medicare and Social Security taxes on all profits, the S corporation and its owner will only pay these taxes on the owner's salary. The remaining profits are not subject to these taxes.

Here's One Example:

Suppose you are an LLC owner taxed as a sole proprietor and your business makes $100,00 profit. You will report $100,000 of income, and you will pay Social Security tax and Medicare tax on the entire $100,000.

Now suppose you have elected to be taxed as an S corp. and have determined that your reasonable salary is $50,000. Your salary is a business expense, so the business now has a $50,000 profit. You will still report $100,000 of income [$50,000 of salary plus $50,000 of profit], but you and your business will only pay Social Security and Medicare taxes on your $50,000 salary.

**But keep in mind, if you pay less money into Social Security and Medicare you may have less money to draw on when you are eligible for those benefit programs. Check with your CPA and financial advisor to determine the best plan for your situation.

"So why hasn't everyone elected S-corp status already if they save so much money in taxes?"

Well, not every business is eligible. Here are the IRS rules:

To qualify for S corporation status, the corporation (or other eligible entity) must meet the following requirements:

• Be a domestic corporation
• Have only allowable shareholders
  • May be individuals (US citizens and permanent residents only), certain trusts, and estates and
  • May not be partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

Now you know the difference. Cheers to you!

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Before deciding on S corporation vs. LLC taxation (or other tax classification), be sure you carefully evaluate the various pros and cons and seek advice from a business lawyer and an accountant.