Business Planning for an S Corporation
S corporations, according to recent IRS statistics, represent the most popular corporate form for doing business in the country. Not surprisingly then, entrepreneurs need to know the differences between business planning for an S corporation and planning for a traditional corporation.
Business Planning Difference #1: No Corporate Income Taxes
If you work with standard business planning software, one of the key variables you input is the corporation's income tax rate. And that makes sense. After a business venture is profitable, corporate income taxes become an important expense and cash flow item to include in the planning.
S corporations, however, don't generally pay federal or state corporate income taxes. This "no corporate taxation" feature means, therefore, that when doing business planning for an S corp, you typically should not estimate any corporate income taxes.
Note: Some states like Tennessee treat S corporations like regular corporations, which means that these corporations in Tennessee do pay state corporate income taxes. Other states in which an S corporation may pay income or income-like taxes on its income or some portion of its income include Michigan and Massachusetts.
Business Planning Difference #2: Distributions for Individual Income Taxes
The profit that an S corporation earns ultimately does get taxed, by the way. What happens, in effect, is that the S corp assigns its profit to shareholders based on their ownership percentages.
Later on, when the shareholders calculate their taxable income and tax liability, they pay the income taxes on those "assigned" corporate profits. A shareholder who owns, for example, twenty of the corporation pays the income taxes on twenty percent of the corporation's profits.
And this fact affects the S corporation business plan. Because S corp shareholders pay the tax bill for the corporation's profits, the business plan should explicitly plan for shareholder distributions so shareholders can pay the income taxes due on their respective shares of the business profit.
Note: When planning shareholder distributions for paying income taxes, you would typically assume the highest marginal income tax. That assumption would mean that all shareholders receive enough money to pay the tax bill. Note, too, that starting in 2013, some inactive shareholders in an S corporation will pay the 3.8% Obamacare medicare surtax on their distributive shares. (Click here to jump to a page at my CPA firm web site that provides more details on the surtax.)
Business Planning Difference #3: Franchise Taxes
A quick planning point: A handful of states levy franchise taxes on S corporations. And an S corporation will owe franchise taxes to any state in which it operates, employs people or owns property.
Accordingly, when doing business planning for an S corporation, you do want to consider the issue of state franchise taxes. Thankfully, the franchise taxes are usually modest--at least as compared to federal income taxes.
Business Planning Difference #4: Plan for S Status Termination
A final business planning point related to S corporations. These corporations can only have certain types of shareholders--essentially US citizens and permanent residents--and can have only a limited number of shareholders.
Note: The shareholder limit is sort of 100 or fewer shareholders, but families often count as one shareholder, so the shareholder count can, practically speaking, rise above 100.
These S corporation eligibility rules mean that if you're doing business planning for an S corporation that will become or may become very successful, you ought to consider the possibility that, at some point, the S corp status will terminate.
For example, perhaps an ineligible S corporation shareholder like a venture capital partnership will acquire shares. (A partnership is not an eligible shareholder.) Or perhaps at some point, the S corp shareholder count will exceed 100 shareholders.
When the S corporation status terminates, the corporation will begin paying taxes on its profits and shareholders will stop paying taxes on the corporation profits.
About the author:
CPA Stephen L. Nelson is the author of Maximizing Employee Retention Credits.