Ask a CPA: What are S-Corp Accounting Firms?
Even by IRS standards, the origin of the name “S-corp” isn’t particularly… thrilling.
(The concept of this taxable corporate entity originates from subchapter “S” of the Internal Revenue Code, hence “S-corp.”)
On the other hand, the unique tax status of an S-corp is very thrilling to anyone seeking to reduce their tax burden.
With that said, what is an S-corp?
How does it differ from other tax classes, like C-corps or partnerships?
How can your business become an S-Corp?
And finally, should your business consider becoming an S-corp? What will be the advantages and drawbacks? And how can an accounting firm help you obtain and manage S-corp status?
Let’s take a look.
‘Double taxation’ is about as fun as it sounds.
To help you understand S-corps, we’ll start by explaining ‘double taxation.’
Clearly, all businesses in the U.S. are required to pay taxes. However, how a business is taxed depends on the business’ tax status. A business’ status (whether it’s a C-corp, S-corp, partnership, or other) determines how its income its taxed. It also determines what rules the business must follow in order to stay compliant with the IRS and maintain its status.
You have probably heard of a C-corp, the most common type of taxable legal entity.
One of the advantages of a C-corp—as well as other corporations—is that its shareholders benefit from ‘limited liability.’ Legally, the corporation is distinct from its shareholders. That means that their liability is limited to their investment. They are not responsible for the debts or other legal liabilities of the corporation beyond the scope of their investment.
(For example, a company may find itself deep in debt. As a result, shareholders may lose some of the money they invested in the corporation, but they are not personally responsible for settling the debt.)
A key advantage of C-corp status that distinguishes it from other taxable entities is their scope and flexibility. The IRS allows C-corps to have an unlimited number of shareholders; this makes it significantly easier to finance growth and go public. (Going public usually involves an exponential increase in the number of shareholders.)
However, there are drawbacks to being a C-corporation.
In exchange for limited liability, greater flexibility and other advantages, owners of C-corps are subject to double taxation.
As the name suggests, double taxation involves the income from a C-corp being taxed twice—once at the corporate level, and again when it’s distributed to shareholders as a dividend. Currently, the corporate income tax rate is 21%. The dividends received by the shareholders are subject to tax at either a 15% or 20% rate, depending on overall income levels. Additionally, the dividend could also be subject to the 3.8% net investment income tax. And it’s not only large, publicly traded corporations. Many small businesses that are partnerships also pay double taxes.
Traditionally, this is seen as a trade-off. If you want the legal benefits of a corporation, you’re going to have to pay more business taxes.
But what if there was no trade-off? What if you could benefit from the limited liability of corporate status without the burden of double taxation?
That’s where S-corps come in.
What is an S-corp?
Like other corporate tax entities, an S-corp offers shareholders the legal and financial protection of limited liability while eliminating double taxation.
When your business is taxed as an S-corp, the IRS allows you to pass corporate income, deductions, losses, and credits through to your shareholders. Because income is passed through the corporation without taxation, S-corps are often called “pass-through” entities.
What does that mean for your business? It means that, as an S-corp, you no longer have to pay federal corporate income tax (though you may still have to pay a state corporate income tax, depending on your location).
Instead, your business’ income is passed through directly to you and other shareholders. Each shareholder reports their share of the income on their individual tax returns, where it is subject to federal and state income tax. The S corporation can then make cash distributions to its shareholders to the extent of the pass-through income previously allocated to them. These distributions, when taken, are not subject to tax again like they would be in the C corporation context.
Self-employment tax savings.
For sole proprietors and partners in partnerships that are active in the management of the business, the business income is subject to self-employment tax under the Federal Insurance Contributions Act (FICA), which is currently 15.3%. (The rate is 15.3% up to $147,000 (for 2022) However, the rate drops to 2.9% for income in excess of this threshold.)
For S corporations, the taxable income that is passed through to the shareholders is not subject to self-employment tax. The IRS requires shareholders in an S Corporation that are actively involved in the management of the business to receive a “reasonable salary” (more on that below). These salaries are subject to self-employment tax (7.65% is withheld from the salary and 7.65% is paid by the company). If the business is profitable, the taxable profits after the shareholders pay themselves a reasonable salary are not subject to self-employment tax, which can provide significant tax savings.
Here’s how that works.
Let’s say you are the single owner of an unincorporated small business (sole proprietorship).
In year 1, your business income was $100,000.
Because your income is less than $147,000, you are subject to the 15.3% self-employment tax rate. You owe $15,300 in FICA taxes.
The next year, with the help of your CPA, you decide that your business would benefit from electing S-corp status.
This year, your corporate income is, once again, $100,000.
This time, however, you pay yourself a salary of $70,000. Your $70,000 salary is subject to the usual 15.3% FICA rate, which adds up to $10,710. You receive the remaining income ($30,000) as a distribution of profits, which is not taxed by FICA.
Therefore, your total FICA burden for the second year is $10,710, rather than $15,300. By transitioning from an unincorporated sole proprietorship to an S-corp, you reduced your FICA burden by more than $4,000—over 4% of your total income.
As you may have noticed, you could, in theory, further reduce your FICA burden by reducing your salary. Only your salary is taxed by FICA, so you could pay yourself a tiny salary, pay the rest as a non-taxable distribution, and minimize your FICA burden, right?
Not so fast. Because of this potential loophole, the IRS puts strict limits on the size of S-corp salaries. According to the law, salaries for the employees of S-corps must be “reasonable.” If a company is caught giving artificially low salaries, they may have to pay back taxes and penalties.
(Of course, what constitutes a “reasonable” salary is open to interpretation. We recommend working with your CPA to establish appropriate salaries. If, however, you’re looking for a reference point, start by considering the average salaries for similar positions on Glassdoor.)
Pros & Cons of being an S-Corp
Being an S-corp certainly comes with its advantages, but it’s not the right fit for every business. Some businesses don’t qualify for S-corp status, while others don’t want to face some of its drawbacks.
- Liability protection: Like other corporate entities, S-corps are legally distinct from their shareholders. As an owner, you are only responsible for your investment in the company—not the company’s debts. It’s also relatively easy to transfer ownership of the company to others.
- No double-taxation: As we discussed above, S-corps pass income, losses, deductions and credits to shareholders, eliminating double-taxation.
- Losses can be passed through: Owners can deduct losses from the business against their other sources of income on their personal income tax return, subject to a few limitations.
- Limited scope: The biggest drawback of S-corp status is that these companies can have no more than 100 shareholders. While that may not be an issue for small businesses, it excludes most larger corporations and makes it difficult to go public. Also, S-corps are permitted to have only one class of stock.
- More red tape: S-corps face greater scrutiny from the IRS, especially when it comes to salary payments versus dividends. They are also required to obey corporate bylaws and take minutes at shareholder meetings (which is also true for C-corps).
- Greater expense: There will be some legal fees involved in establishing your S-corp business entity. Maintaining the status also requires somewhat more accounting work than is involved in other entities (this is also true for C-corps). However, with the potential savings, it may be worth the cost.
What are S-corp CPA firms?
S-corp CPA firms are simply accounting firms that specialize in helping businesses consider, obtain, and manage S-corp status.
Specializing in medium-sized businesses, Dugan & Lopatka is among the top S-Corp accounting firms in Chicago, as well as one of the leading full-service accounting firms in Chicago’s suburbs.
Our S-corp accountants work closely with your business to help you identify your options, weigh the pros and cons of becoming an S-corp, and lead you through the application process and maintenance of your status.
Learn more about our accounting services, business consulting, and tax services here.