All corporations start out as C Corporations.
To create a corporation, you need to file articles of incorporation with the secretary of state (department of state) in the state where you want to create it. The articles of incorporation include the corporation’s basic information: name, street and mailing addresses, registered agent’s information, incorporator’s information and the number and types of shares (stock) being issued by the corporation.
After you properly file the articles of incorporation and pay the filing fee, the state will accept your filing. Congratulations! A new corporation is born! If you do nothing else, your corporation will simply remain a C Corp.
C Corps make no special tax elections with the IRS. All income earned by a C Corp is currently taxed at a flat corporate income tax rate of 21%. You might be thinking, “That doesn’t sound so bad!” since the highest individual income tax rate for 2018 was 37%. However, remember that all of the C Corp’s income is in its own bank account until it is paid to you. When you pay yourself a shareholder dividend from your C Corp’s bank account you will be taxed on it again at either your individual tax rate (for dividends taxed as short term capital gains) or at the long term capital gains rate (either 0%, 15% or 20%).
That is double taxation!
The following example shows what would happen at the end of 2018 if your C Corp earns $100,000.00 in net income before taxes and then pays you whatever is left as a shareholder dividend that is considered a short term capital gain and is taxed at your individual income tax rate of 22%.
| C Corp Pays you Dividends in 2018
(Considered Short Term Capital Gains) |
|
| C Corp Net Income before taxes | $100,000.00 |
| C Corp Taxes Due (21% corporate income tax rate) | ($21,000.00) |
| C Corp Net Income after Taxes | $79,000.00 |
| Your Individual Taxes Due (22% individual income tax rate) | ($17,380.00) |
| Your Net Income after Taxes | $61,620.00 |
Let’s take a look at another example.
The following example shows what would happen at the end of 2018 if your C Corp earns $100,000.00 in net income before taxes and then pays you whatever is left as a shareholder dividend that is considered a long term capital gain and is taxed at the 15% rate.
| C Corp Pays you Dividends in 2018
(Considered Long Term Capital Gains at the 15% Rate) |
|
| C Corp Net Income before taxes | $100,000.00 |
| C Corp Taxes Due (21% corporate income tax rate) | ($21,000.00) |
| C Corp Net Income after Taxes | $79,000.00 |
| Your Short Term Capital Gains Due (15% long term capital gains tax rate) | ($11,850.00) |
| Your Net Income after Taxes | $67,150.00 |
The second scenario looks a little better than the first scenario, but you are still paying taxes on the same money twice. S Corporations help you avoid double taxation.
Let’s go back to when you first filed your articles of incorporation. Your new corporation starts out as a C Corp, but if you elect S Corp status with the IRS, everything changes. To elect S Corp status with the IRS, you will need to file IRS Form 2553 within 75 days (two months and 15 days) after your corporation is born (or within 75 days after the beginning of tax year in which the election is to take effect). Note that a C Corp and an S Corp are legally the same. The difference is that the S Corp makes a tax election with the IRS using Form 2553 and the C Corp does not.
Assuming you filed your IRS Form 2553 in time for 2018, let’s take a look at another example using the same figures used in the first example above.
The following example shows what would happen at the end of 2018 if your S Corp earns $100,000.00 in net income and then pays you whatever is left as a shareholder distribution taxed at your individual income tax rate of 22%. Note that S Corps pay profit distributions and C Corps pay dividends.
| S Corp Pays you Distributions in 2018
(Taxed at your Individual 22% Income Tax Rate) |
|
| S Corp Net Income before taxes | $100,000.00 |
| S Corp Taxes Due (0% corporate income tax rate) | ($0.00) |
| S Corp Net Income after Taxes | $100,000.00 |
| Your Individual Taxes Due (22% individual income tax rate) | ($22,000.00) |
| Your Net Income after Taxes | $78,000.00 |
Wow! By electing to be taxed as an S Corp, the money paid to you as shareholder profit distributions simply passes through to you and is not subject to any corporate income tax resulting in a net savings of $16,380.00.
One other advantage available to S Corps that is not available to C Corps is the savings you can achieve by paying yourself profit distributions instead of salary. Money you pay to yourself from your S Corp as salary is subject to Social Security and Medicare taxes. The rate is 15.3%.
Let’s say you have $100,000 to pay yourself from your S Corp in 2018. If you pay all of it to yourself as salary, in addition to your normal federal income taxes taxed at a rate of 22% at the end of the year you will first have to pay 15.3% in Social Security and Medicare taxes as part of your payroll withholding. However, if you classify a portion of the money paid to yourself as profit distributions, you can lower your Social Security and Medicare tax liability.
Take a look at the two scenarios below. In the scenario on the left, all of your S Corp’s net income is paid to you as salary. In the scenario on the right, $70,000.00 of your S Corp’s net income is paid to you as salary and the remaining $30,000.00 is paid to you as a profit distribution (which is not subject to Social Security and Medicare taxes).
| S Corp pays you $100,000 salary | S Corp pays you $70,000 salary and $30,000 in profit distributions |
| 15.3% Payroll Tax on $100,000 ($15,300.00) | 15.3% Payroll Tax on $70,000 ($10,710.00) |
| 22% Income Tax ($18,634.00) | 22% Income Tax ($19,643.80) |
| Net Cash $66,066.00 | Net Cash $69,646.20 |
When you classify a portion of your pay as profit distributions in this example, you net $3,580.20 more in cash to yourself. However, paying yourself too much in profit distributions can result in an IRS audit and may require you to reclassify the payments you receive, so seek advice from a professional on how to do this right!
Finally, note that there are certain restrictions on who can own an S Corp and also on the type of stock S Corps may issue to their shareholders. We will go over that in a separate article.
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