A few months ago we discussed some of the benefits and drawbacks associated with forming a business as a corporation. Generally, the corporation structure is ideal for larger businesses with high numbers of shareholders or startup companies that are anticipating obtaining funding from traditional private equity sources (or possibly going public down the road). Conversely, for many small businesses, the corporation is not always the best entity option for a variety of reasons, including the necessity of following cumbersome formalities and the additional professional fees associated with maintaining these formalities. However, another reason (which we did not discuss in the last article) that the corporation form may be (or may not be) the right option for a particular business relates to taxes. This month we are going to specifically address taxation in the context of corporations and answer a question that even sophisticated business owners and entrepreneurs often do not completely understand: what is the difference between a c-corporation and an s-corporation (and why should a business owner care)?
Introduction to C-corporations and S-corporations
From a legal standpoint, c-corporations and s-corporations are pretty much exactly the same. Both are created by filing Articles of Incorporation in a particular state, both issue shares in exchange for capital, both provide shareholders with limited liability, and both are managed by directors and officers. The main distinction between c-corporations and s-corporations arises in the IRS Code and relates to taxation.
Upon formation, an entity must choose or elect how it will be taxed. Corporations have two potential taxation options: they can be taxed as a c-corporation or an s-corporation. C-corporations are taxed pursuant to the rules and regulations of subchapter C of the IRS Code (hence the “C”) and s-corporations are taxed pursuant to the rules and regulations of subchapter S of the IRS Code (hence the “S”).
Subchapter C provides for a concept known as “double taxation” whereby taxes are paid on the corporation’s earnings on two different levels. On the first level, the corporation pays tax on all net earnings at its respective corporate tax rate (which is usually around 35%). On the next level, each individual shareholder pays tax (at the dividend tax rate) on all earnings distributed to the shareholder in the form of dividends (this tax rate is between 15% and 20%). As you can see, this tax structure results in a significant outflow of corporate earnings into the pockets of Uncle Sam and, therefore, is often not ideal for many businesses (especially small businesses and startups).
Taxing Limited Liability Companies (LLCs)
In order to truly understand the tax savings available to an entity structured as an s-corporation, it is also helpful to understand how LLC’s and partnerships are generally taxed. In some ways, owners of an LLC (referred to as “members”) taxed as a disregarded entity or partnership also pay two forms of tax (just like shareholders of a c-corporation). First, the earnings of an LLC allocated to a particular member are taxed at the ordinary income tax rate. The ordinary income tax rate is on a sliding scale and ranges anywhere from 10% to 40% depending on an individual’s total income. Second, on those same earnings, the member will also pay an additional tax often referred to as the “self-employment tax.” This tax is a combination of Social Security and Medicare taxes and, as of the date of this post, is around 15% on all income up to $118,000.00 and 3% on any additional income above $118,000.00. Thus, the member pays tax at both the ordinary income tax rate and the self-employment tax rate, often resulting in a large outflow of cash to the IRS.
Subchapter S of the IRS Code, on the other hand, has a different tax structure which can result in a significantly lower overall tax rate for shareholders of businesses structured in this manner. S-corporations are not subject to “double taxation” (as corporations are) and they also provide a means of avoiding the “self-employment tax” associated with LLCs/partnerships. Instead, a shareholder of an s-corporation pays tax at the ordinary income tax rate on its portion of the company’s earnings. There is no self-employment tax that must be paid in addition to that rate. Thus, the outflow of taxes for shareholders of an s-corporation can be significantly lower when compared to c-corporations and LLCs taxed as partnerships because there is no double taxation and no self-employment tax is assessed (caveats to come).
What’s the Catch?
Like most things in life, there is a catch to the s-corporation structure. Actually, there are several exceptions and limitations that come into play that may disqualify a business from being structured as an s-corporation or make the structure less favorable. First, an s-corporation cannot have more than 100 shareholders. Thus, this structure is not available for larger corporations. Second, entities cannot be shareholders of an s-corporation. Thus, an s-corporation cannot seek funding from most traditional private equity sources. Third, s-corporations can only have one class of stock and all distributions must be allocated based on a shareholder’s respective percentage of ownership. In LLCs and partnerships, distributions can be adjusted however the members may agree, but this flexibility is not available with s-corporations.
One More Catch: Reasonable Wage
Finally, there is one more major limitation that comes into play with s-corporations. Shareholders that work for an s-corporation must (1) be hired on as W-2 employees of the company and (2) receive “reasonable wages.” At first glance, this requirement may not seem that important, but it can be a game changer and make the s-corporation structure less favorable for shareholders from a tax perspective. How? It all depends on the shareholder’s “reasonable wage.”
To start, the tax impact of W-2 wages on a shareholder/company structured as an s-corporation is similar to the tax burden on a member of an LLC as discussed above, so paying a shareholder W-2 wages does not present a tax advantage for the shareholder. However, if the shareholder’s reasonable wage when compared to its portion of the company’s total earnings is low, the shareholder will benefit from the s-corporation structure because it will avoid paying self-employment tax on all earnings that are not wages. However, there are situations where the shareholder’s reasonable wage is so high that it leaves the corporation with little to no excess earnings with which to distribute to the shareholder at the ordinary income rate. In such a situation, the s-corporation structure does not help the shareholder because the shareholder is not able to take advantage of the no-self-employment-tax feature available for s-corporation distributions.
Determining what is a “reasonable wage” is as much an art as it is a science; the IRS doesn’t provide a lot of guidance on the term. As a general rule, industry standard wages for a particular position is a good place to start (i.e., what would it cost to hire someone that is not a shareholder to fill the position?). However, prior to setting the wage for a shareholder of an s-corporation, an accountant or tax attorney must be consulted in order to ensure the wage can properly be classified as “reasonable.”
The s-corporation can be an excellent structure for owners of small businesses and startups that are looking to reduce their tax liability. However, not all businesses are able to comply with the s-corporation mandates and requirements. Furthermore, the s-corporation structure may simply not make sense where a shareholder works for the company and that shareholder’s “reasonable wage” is such that there are little to no excess earnings available for distribution to the shareholder. Given the complexities associated with this structure, prior to electing to be taxed as an s-corporation, business owners should consult a trusted accountant or attorney in order to determine whether this structure is the right option for the business. Although this topic is somewhat complicated, the tax savings for some business owners can be significant and, therefore, it is worth taking the time to determine if it is the right structure for you and your business.