Taxation and classification of Texas corporations
By default, a Texas corporation is taxed as a c-corporation. However, many small businesses elect to be taxed as an s-corporation. In this article, we will discuss generally the effects of both options on their respective shareholders.
A regular corporation (also known as a c-corporation) is subject to corporate taxes and must file tax returns (Form 1120) each year. If, and only if, the shareholders receive a dividend from the corporation, such shareholder would have to pay income tax on the dividend. As you can see, dividends paid to shareholders of a c-corporation are essentially taxed twice. They are taxed once at the corporate level (on the c-corporation’s Form 1120), and again at the shareholder level (on the shareholder’s Form 1040). Unlike an s-corporation, a shareholder of c-corporation is taxed on dividends only when those dividends are actually paid out.
Unlike a c-corporation, an s-corporation is generally not subject to corporate taxes. Specifically, an s-corporation is exempt from federal income tax other than tax on certain capital gains and passive income. The s-corporation is considered a "pass-through" or "flow-through" entity. In other words, the s-corporation’s income (or net losses) passes through the corporation to the shareholders for federal income tax purposes (even if the shareholder does not receive a dividend). The s-corporation’s profits are taxed each year on each shareholder’s Form 1040. It is important to remember that an s-corporation’s shareholders will have to pay taxes on ALL of the s-corporation’s profits event if they do not receive a dime.What is required to be taxed as an S corporation? → What is the definition of an S-corp →
One of the benefits of electing to be taxed as an s-corporation is the potential tax savings related to self-employment taxes (i.e. Social Security and Medicare). A shareholder who is also an employee of the s-corporation (shareholder-employee) only pays self-employment taxes on his or her salary. The remaining profits that are attributable to this same shareholder would NOT be subject to the 15.3% self-employment tax. Let’s assume the s-corporation has one shareholder who is also an employee and the s-corporation has $100,000 in profits in year 1. If the shareholder was also an employee and had a $40,000 salary, the shareholder would only have to pay the 15.3% self-employment tax on the $40,000 salary (not the entire $100,000 in profits). Do not be tempted to pay yourself an unreasonably low salary to avoid self-employment taxes, the IRS has said over and over again that s-corporations must pay their shareholder-employees a "reasonable compensation" for services rendered to the business.
The ability to minimize self-employment tax can be a huge benefit, but is very complex. Should you have questions about self-employment or income taxes, including the implications of your entity decision and IRS elections, you should consult your tax professional.
The Key Points
The dividends paid to shareholders of a c-corporation are essentially taxed twice. However, the shareholders do not pay income tax of the business profits unless and until they receive a dividend.
S-corporations avoid "double taxation", but the shareholders must pay income tax on all profits even if the s-corporation decides to retain the profits. In other words, all profits are deemed to be distributed to shareholders EACH YEAR.
A shareholder who is also an employee of an s-corporation, may enjoy self-employment tax savings, provided the shareholder-employee receives "reasonable compensation" for services rendered to the business. If your salary is too small, it will not be “reasonable” and the SE Tax will be payable on the entire profit.