I have been doing a lot of writing on the difference between S-Corporations and C-Corporations. The fact the matter is that most of tax accountants will automatically recommend S-Corporations over C-Corporations, to their client base as the only option available. However, I would like to spend some time to dispel that myth. A subchapter S-Corporation can work with most scenarios. However, let’s explore the world of the S-Corporation versus the C-Corporation.
In an S-Corporation the corporation itself does not pay any income tax. The profits and losses, simply flow over to the shareholder to be claimed on the shareholder’s personal tax return. The benefit to this, is that the shareholder like his tax on this money one time. The other benefit is that there is no self-employment tax when there is a profit. S-Corporations just like Partnerships are known as flow through entities. It is your typical small business entity of choice.
However, the problem arises where an S-Corporation has to follow very strict rules. For instance, you may only have 100 shareholders as an S-Corporation. All of the shareholders must be US citizens or resident aliens.
Another problem with an S-Corporation, is the deductibility of certain expenses. For instance, you cannot deduct charitable contributions. These are listed on schedule K-1 and flow through to be claimed on your personal tax return. Another problem with the S-Corporation structure, is that you cannot deduct the cost of self-employed health insurance. This deduction, has to be added to your wages and made subject to Social Security and Medicare tax. Then, you deduct them on Form 1040. Further, the cost of life insurance is also not deductible.
Now we get into something called reasonable compensation. All shareholders of an S-Corporation must reasonably compensate themselves. There are several United States Tax Court cases that discuss reasonable compensation. Typically, reasonable compensation are wages that are paid to you, that would be paid to anyone doing the same job anywhere else. Compensation, is subject to Social Security and Medicare tax, not to mention federal and state unemployment.
In an S-Corporation, you can also take distributions. This is provided, that you are reasonably compensating yourself. Distributions, are not subject to self-employment tax. It is simply you taking the profit of the Corporation. Another problem that arises with an S-Corporation, is that when the money flows over to you on your personal return you have to claim it at your ordinary income tax bracket. This can be as high as 39.6%.
On the other hand, in a C-Corporation the rules are a little bit more liberal. Your health insurance, is 100% deductible to the Corporation. You do not have to subject these amounts to Social Security and Medicare tax. You can simply start an IRC § 125 plan, and exempt the amounts paid from tax. Further, life insurance, provided it is less than $50,000 is deductible to the Corporation. Donations are deductible as well. You can also start a health care reimbursement plan through C-Corporation. The way that you get money out of the C-Corporation, is through a mixture of salary and deferred compensation. Deferred compensation, is basically a retirement plan, where you can deduct a higher amount of employee benefits.
What it all basically boils down to, is how much money you are going to make.