By: William J. Barnes, CPA, CVA, MST
When choosing to incorporate a business an important decision to consider is whether to be a C Corporation or an S Corporation. The right choice can save you income taxes and employment taxes as well as other headaches.
Below is a 10,000 foot view that can help you analyze which business form is right for your particular situation.
Basics
Main difference is a C Corporation pays federal income taxes on its business income. An S Corporation generally pays no federal income tax on its business income. Rather, the shareholders of the business pay income tax on the business income on their personal tax returns.
Example
Lets say ABC Corporation has taxable income of $1,000,000 – below is comparison of different tax consequences (ignoring state taxes):
C Corp S Corp
Taxable Income $ 1,000,000 $1,000,000
Federal Tax at 34% ($ 340,000) $ 0
Cash Available S/H - Dividend $ 660,000 $1,000,000
Tax to Shareholder Dividend 15% ($ 99,000)
Tax on Income S/H 35% ( $350,000)
Net Cash to S/H $ 561,000 $ 650,000
Effective Tax Rate 43.9% 35.0%
Additional Tax C Corporation $ 89,000
You might think that, based on this example and tax savings, an S Corporation is always the better choice. However, choosing the better corporate tax treatment is a little trickier than it appears.
Reasons to choose C Corporation status:
Ø Graduated tax rates – tax rate on first $50,000 of income is 15%.
Ø Income is expected to be $100,000 or less.
Ø More income can be retained for future growth because of graduated rates.
Ø Tax free fringe benefits.
Ø Flexibility for tax year ends.
Reasons to choose S Corporation status:
Ø Avoid double taxation on profits.
Ø Saving on employment taxes.
Ø Can shift income to family members who are taxes at lower rates.
Ø Greater flexibility to use cash method of accounting.
Ø For tax years beginning after December 31, 2011, S Corporations will no longer be subject any Michigan Corporate Income Taxes.
By default a corporation is generally considered a "C" corporation. If you desire to be taxed as an "S" corporation you must file a Form 2553 to inform the IRS that the shareholders desire (elect) this tax treatment.
Not all corporations may elect S status. The election is only available to qualifying small business corporations who have no more than 100 shareholders, only one class of stock and eligible shareholders.
Careful planning should go into the decision to be a C Corporation or an S Corporation. Taxpayers should seek out professional tax advice to help in the decision process.