Taxes are a fact of life, but that doesn’t mean you should pay more than you have to. By making smart choices, you can keep your tax bill as low as possible without getting on the wrong side of the IRS. This is especially true for small businesses and entrepreneurs, where the structure of your business can have a big impact on your taxes.
The main thing to understand is whether your business is its own tax-paying entity or if the profits are taxed as part of your personal income. This is where the difference between a C Corporation and an S Corporation comes in.
A C Corporation is taxed separately from its owners. It files its own tax return (IRS Form 1120) and pays taxes on its profits at the corporate tax rate. But here’s where it can get tricky for small business owners: if the corporation pays out dividends to its shareholders, those dividends are taxed again on the shareholders’ personal tax returns. This is known as double taxation.
To avoid this, a corporation can choose to become an S Corporation. In this case, the corporation itself doesn’t pay taxes on its profits. Instead, the profits (or losses) are passed on to the shareholders, who report them on their personal tax returns. So if you own a third of an S Corporation, you’ll report a third of the company’s profits on your personal tax return. This is the main difference between a C Corporation and an S Corporation.
There are a few other things to know about S Corporations. First, you can also pass on losses to your personal tax return, which can offset other income. Second, you have to report your share of the profits even if you don’t actually receive them as a distribution. So if you own all of an S Corporation and decide to leave all the profits in the business for future investments, you still have to report the profits on your personal tax return. If you plan to keep a lot of money in the business, you might be better off as a C Corporation.
One advantage of an S Corporation is that distributions aren’t subject to self-employment taxes, which can help self-employed entrepreneurs reduce their tax bill. But if you’re actively working in the business, you have to pay yourself a reasonable salary, which is subject to self-employment tax.
Interestingly, an LLC (Limited Liability Company) can also choose to be taxed as an S Corporation. This allows the owner to split the business’s earnings into salary and distributions, which can provide a tax advantage.
However, not every business can qualify as an S Corporation. The IRS has strict requirements, including that the corporation must be domestic, shareholders can’t be partnerships, corporations or non-resident aliens, there can’t be more than 100 shareholders, there can only be one class of stock, and certain types of companies aren’t eligible.
To become an S Corporation, you need to file IRS Form 2553. But be aware of the deadline: you need to file the form no more than two months and 15 days after the start of the tax year when the election will take effect.
As the deadline approaches, consider whether an S Corporation is the right choice for your business. A tax advisor or small business expert can help you make the right decision.
