Pass-through taxation businesses like sole proprietorships, partnerships, LLCs, and S Corps continue to increase in number in the U.S., making them a dominant type of business.

In the meantime, the number of C Corporations continues to fall, with figures published by the Tax Foundation indicating that the number of pass-through companies was 20 times higher than the number of corporations. In addition, the Tax Foundation quotes the 2013 IRS report, showing there were 1.6 million corporations in 2013 compared to 2.6 million in 1986.

Many startup owners wonder about the best form of taxation for their new enterprise. Here are some facts about pass-through taxation and the benefits of choosing an S Corp.

Understanding Pass-Through Taxation

The difference between pass-through and corporate taxation is that pass-through businesses face only one layer of tax compared to the double taxation corporations pay (first at the entity level and then as an income by the owners or shareholders after receiving dividends).

Also, pass-through business owners must pay an annual tax on their entire business income. In contrast, C Corporation owners can defer the tax by not withdrawing their share of the corporate income.

Choosing S Corp Status

Many business owners choose the S Corporation tax status after forming a limited liability company or corporation. The tax status is part of the IRS tax code under Subchapter S, allowing business owners to save tax by becoming company employees.

Taxation Difference Between an LLC and S Corp

One of the reasons some LLC owners choose the S Corp tax designation is to pay tax as employees of the enterprise, allowing them to save on self-employment taxes. The tax designation also enables them to contribute to their retirement and health insurance pre-tax.

S Corp owners pay income tax on the rest of their distributions according to their tax bracket. However, if they choose the default LLC tax status, they pay employment and income taxes on their whole income.

Yet, S Corp status does not save all businesses money, especially if they don’t make enough profit to pay the owners a reasonable salary and make annual distributions of at least $10,000.

Small businesses that need to reinvest profits for their growth should prefer the default LLC tax status.

What is Pass-Through Taxation?

Tax Difference Between S Corp and C Corp

C Corporations have a flat tax rate that is currently at 21%. Once shareholders receive their distributions, they declare them on their personal tax return, paying tax on the income according to their tax bracket.

S Corps don’t pay tax at the business level because of their pass-through status. Therefore, they have no tax rate. Instead, the owners pay employment and income tax on a reasonable salary and income tax on the distributions. The income from the distributions is also subject to state tax.

Careful consideration is required before a corporation chooses S Corp status because this negates some of its essential benefits.

Requirements and Disadvantages of an S Corp

S Corps do have some specific requirements and restrictions. These include up to 100 shareholders only who are U.S. citizens or permanent resident aliens. In addition, no business entity can own an S Corp, and it can only issue one class of stock.

An S Corp can only be a domestic corporation with a board of directors, and everyone must agree to the S Corp status. Furthermore, they must record minute meetings and meet the specific deadlines of the IRS.

Determining the Viability of S Corp Status

TRUiC’s S Corp tax calculator can help determine if your business will save by choosing the S Corp tax designation.

First, determine a reasonable salary for your work designation in the business by researching similar salaries online. Next, make a conservative estimate of the company’s annual net profit. Finally, add the two amounts to the calculator to determine if you meet the criteria to save from the tax designation.

Electing S Corp Status

Suppose your business meets the S Corp requirements and can pay you a reasonable salary and at least $10,000 in annual distributions. In that case, it will likely meet the added cost of maintaining the tax designation.

The S Corp status is easy to elect. The process is done through the IRS by filing Form 2553 when getting an EIN or at a later stage.

Final Comment

Pass-through taxation allows business owners to pass their income and losses onto their personal tax returns but only pay one layer of tax, compared to the two paid by corporations. Besides sole proprietorships and partnerships, an LLC, with its default pass-through taxation, is another popular business entity in the U.S. However, LLCs and corporations can also choose the S Corp tax designation, a tax status from the IRS, allowing domestic companies that meet other requirements to save money on self-employment taxes.