When people discuss passthrough taxation they are either talking about a partnership or an S-corporation. Both function in a similar fashion, income “flows” through the entity and it is taxed at the individual level rather than at the entity level. However, there are some key differences to consider.
What is an S-corporation?
An S-corporation is an entity that has elected treatment under Subchapter S of Title 26. An election is made by timely filing the Form 2553 with the IRS. An eligible entity must:
- Be a domestic corporation,
- Have only allowable shareholders (individuals, certain trusts, and estates and not partnerships, corporations, or non-resident alien shareholders),
- Have no more than 100 shareholders,
- Have only one class of stock, and
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
The first requirement, “be a corporation,” can mean one of two things. Either the entity can be organized as corporation for state law purposes. Or, the entity can be an LLC or a partnership that has elected to be treated as a corporation for federal income tax purposes. In either of those cases, the entity would be a corporation for purposes of an S-election and could elect to be treated as an S-corporation.
Pros and Cons of the S-corporation:
Salary and Dividends
An S-corporation can pay the shareholders a salary and treat the rest of its profits as a dividend. As long as the salary is reasonable, self-employment FICA (social security and Medicare) taxes are only applicable to the portion that is a salary. Compare this to a partnership where all the profits are subject to FICA taxes.
Limitations on Shareholders
As mentioned above, the S-corporation has some special rules that prohibits certain people and entities from being shareholders. Specifically, shareholders can be individuals, specific trusts and estates, or certain tax-exempt organizations (501(c)(3)). The shareholders cannot be partnerships, corporations, and nonresident aliens.
Limitations on Special Allocations
Unlike with a partnership that can allocate profits, loss, and depreciation in a plethora of different ways, an S-corporation is limited to an allocation that follows the shareholders ownership of the entity. In addition, S-corporations cannot have different classes of stock.
An S-election may help shareholders decrease their FICA taxes in certain circumstances. It can also be easier and cheaper to incorporate as a corporation for state law purposes since corporations tend to be more straight forward. On the other hand, a partnership or LLC may provide the owners with more flexibility in structuring their arrangement. Choosing whether to make an S-election should be done with consultation with an attorney and qualified CPA. Professionals can walk you through whether an election makes sense for your business and tax needs.