Tax law sets the difference between the C-Corporation and an S-Corporation. When a corporation is formed at the state level, the C-Corporation is the default. The C-Corporation can then, voluntarily, file an election form with the IRS (Form 2553) to become an S-Corporation. Once accepted, your corporation becomes an S-Corporation.
Why go through the trouble of making the ‘S’ election? In short, so the corporation would pay no Federal income tax on its profits. Instead, the S-Corporation’s profits are allocated to the shareholders (the ‘owners’) on a pro-rata basis (e.g. if you own 50% of an S-Corporation, 50% of the profits are allocated to you personally).
Each S-Corporation shareholder then includes the appropriate share of the corporation’s profit on his or her personal tax return, and pays income taxes personally on that income. Why is this beneficial? This avoids ‘double taxation’ experienced by C-Corporation shareholders.
For example, a C-Corporation with two equal shareholders has a net profit of $100. At today’s Federal corporate income tax rates, the C-Corporation would pay a maximum rate of 35% on its profit, or $35. If the C-Corporation pays the remaining $65 as dividends to its two shareholders ($32.50 to each), they would each pay a maximum income tax rate on dividends of 20% (today’s top qualified dividend rate for dividends). As a result, each shareholder would pay $6.50 in personal Federal income tax on the dividend received. Altogether, the C-Corporation and the two shareholders paid a grand total of $48 in Federal income tax on the $100 in profit.
If the corporation in the example above was an S-Corporation, it would pay absolutely no Federal income tax. Instead, the entire $100 net profit is allocated to the two equal shareholders ($50 to each). Then, each shareholder would pay a maximum personal income tax of 39.6% (today’s top rate for ordinary income) on the $50 allocated to him or her. As a result, each shareholder would pay $19.80 in personal Federal income tax on the amount allocated. Altogether, the S-Corporation and the two shareholders paid a grand total of $39.6 in Federal income tax on the $100 in profit.
As illustrated by the (very simplistic) examples above, there can be significant tax savings for shareholders of an S-Corporation. Keep in mind, however, that S-Corporation net profits are allocated to its shareholders automatically – even if the shareholders do not receive any distributions (cash) to cover the tax.
If you are interested in more detail related to your situation it is best to speak with an attorney.
Andrei Tsygankov is the Co-Founder and COO of SmartUp® and a partner at Founders Legal (Bekiares Eliezer LLP). As an attorney, Andrei specializes in corporate, commercial, trademark, and international business matters.
Source: Smartup Legal