Taxation and classification of Texas corporations
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.
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 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.
*Please note that tax issues are complex and we are business formation attorneys, not tax specialists. As such, we must recommend that you consult a tax professional if you have specific questions or special circumstances. According to IRS Circular 230 to ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this writing was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.