When we are talking about business structures, it is important to remember that there are two concepts you must keep straight:  1) the type of entity (or the legal reality) and 2) the IRS’ treatment of the entity.  The first is a question of state law, the second is a question or IRS regulations and US tax law.

Legal Reality of an S-Corp.  There is no legal entity called an “S-Corp”.  The term “S-Corp” refers to a tax status.  Remember, the type of entity and the IRS’ treatment of the entity are two different things.  An S-Corp is an entity (Corporation or LLC) that has been formed under state law (like any other entity) and subsequently has elected to be taxed under subchapter S of the IRC.  But since there is no legal entity called an S-Corp, the prospective owner forms a corporation (or an LLC) with the state and then files forms with the IRS (Form 2553) to elect “S-Corp” treatment.

Historically, the idea behind subchapter S was to allow pass-through tax treatment for corporations.  Traditional corporations filed a tax return and paid tax on profits, shareholders then paid tax again (the so-called “double-taxation”) on earnings when received.  An entity taxed under subchapter S does not file a tax return or pay taxes on profits.  Instead, shareholders report profits and losses on their personal return.

Now that the LLC has become so common, someone considering an S-Corp should ask if it would not be better to simply form an LLC.  The LLC is much simpler to establish and operate, and provides similar tax treatment.  There may be a reason (or several) not to go the LLC route, but you should make sure there is one before going the more complex route.

Advantages.  The advantage of the S-Corp is the tax treatment, this is what it is all about.  See the tax treatment section below for details.

Disadvantages.  The tax treatment of the S-Corp comes at a price.  In contrast with the accounting ease of an LLC, the accounting requirements of an S-Corp are in detail and complexity much more along the lines of a traditional corporation.  So, too, are the requirements for formality in the maintenance of the entity (e.g., shareholder meetings, recorded resolutions authorizing major purchases, entering into contracts, dealing with employee matters, etc.).

There are also numerous limitations on the ownership of an S-Corp.  The shareholders must be individuals (not Corporations or LLCs), there may be no more than 75 shareholders, there may only be one class of stock, and other restrictions.

Tax Treatment.  Time to take a deep breath.  This is really the point, but it is a little complicated.  What differentiates an S-Corp from a traditional corporation (called a “C-Corp” in tax lingo) is that while a C-Corp pays taxes on profits, and then the owner(s) in turn pay taxes on receipt of the profits; the profits and losses of an S-Corp pass through to the shareholder(s) personal tax return(s).  The corporation itself is not taxed, only the shareholder(s).  Hence, no “double-taxation”.

Sounds like an LLC, right?  It should.  But there is a difference.  In an LLC (that has not elected S-Corp treatment) all profits and losses are passed through to the owner(s) as profits or losses and reported on the owner(s)’ personal tax return.  The result is that the owner(s) pay self-employment tax on the entire net income.  (An LLC that has not elected S-Chapter treatment cannot pay a salary to an owner.)

With S-Corp treatment, the corporation has the option of paying its shareholder(s) a salary.  (An LLC that has not elected S-Chapter treatment cannot pay a salary to an owner.)  Employment taxes are paid on the salary, but the rest of the profits “pass through” as a distribution and are not subject to employment taxes (though they are still subject to income tax regardless of whether or not they are distributed to the owner(s)).

But there are a couple of important caveats.  The first is that prior to taking distributions (and regardless of whether they actually do) the owner/shareholder must be paid a reasonable salary for services rendered.  (This is true of a C-Corp as well.)  What constitutes a “reasonable salary” may be open to some debate, but a starting point is what you would expect to get paid if you were doing the same job for someone else.  If you try to cheat the system by paying yourself a basement-wage and taking most revenue as profits (thereby paying less employment tax) the IRS may reclassify the income as wages and assess the tax.

The second point to remember (and it is often overlooked) is that there is a maximum threshold for employment taxes.  In 2013, the maximum income subject to the self-employment tax is $113,700.00.  This means that if your “reasonable salary” is near or in excess of this amount, the S-Corp system is not going to save you any money over pass-through treatment.  (In fact, the higher accounting and compliance costs mean it will cost you money!)

Finally, not all states offer S-Corps the same pass-through treatment as does the IRS, and some require additional filings.  North Carolina honors the Federal ‘S’ election, but imposes a franchise tax which is applicable to S-Corps.  A North Carolina LLC, on the other hand, does not pay the franchise tax.  As with an LLC, it is important to consider where you will be doing business and the tax impact of your choices in those states.

So why an S-corp?  There can be many reasons, but in general they reduce to two.  First, an LLC with an owner whose “reasonable salary” is well below the maximum self-employment tax threshold but has an LLC with net revenue much greater that that amount.  The second is the owner for whom the LLC structure is not as advantageous as a traditional corporation, but for whom pass-through tax treatment is preferable.  It is not for everyone.  As we say so often, the particulars of your situation matter.

One further note:  North Carolina law requires certain categories of licensed professionals to form a PC (which stands for Professional Corporation) or a PLLC.  There is nothing to prevent a PC or a PLLC from seeking S-Corp treatment, though the “reasonable salary” for most of the applicable professions is sufficiently high that it is rarely worthwhile to do so.

Feel free to contact us for a consultation where we can review your situation and discuss the specific pros and cons in your business.