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I'd like to start off this article by clarifying the difference between choice of legal entity and the way an entity elects to be taxed. Under IRC 7701, eligible entities may elect to be taxed as a corporate entity (commonly referred to as C Corp) or as a disregarded entities (commonly referred to partnership - multiple members - or a sole proprietorship - single member). The election is made on Form 8832. After electing to be taxed as a corporate entity, the entity may then elect to be taxed under Subchapter S by filing form 2553. Note that these elections may be made regardless of the legal form that the entity takes (corporation, LLC, etc.).
Below, I will describe some of the key differences between being taxed as a disregarded entity as compared to being taxed as a S corp. Note that this list is not comprehensive and only serves to attempt to address the major considerations when choosing entity classification.
Self-employment tax - One of perhaps the biggest considerations in choosing an entity tax is the self-employment tax (15.3%). Whereas members of a disregarded entity will be subject to self employment taxes on 100% of the entity's income, shareholders of a S corp will only be subject to payroll taxes (the difference between self employment and payroll taxes is that with payroll taxes, half the tax is paid by the employer) on their wages. The portion of earnings distributed to the shareholders from retained earnings will be treated as a nontaxable dividend instead.
Reasonable compensation - The IRS continues to crack down on owners of S corps which do not pay their shareholders a reasonable compensation. Reasonable compensation is determined based on the facts and circumstances surrounding a business as well as industry standards.
S corp restrictions - S corporations have several restrictions including:
a) Must have 100 shareholders or less;
b) Cannot have more than one class of stock (which also restricts the structure of distributions, liquidation and voting rights);
c) Must be a domestic corporation;
d) Must have allowable shareholders (may be individuals, certain trusts or estates and cannot be partnerships, corporations or non-resident aliens); and
e) Will have an additional tax assessed if more than 25% of it's income originates from passive sources.Potential state tax ramifications - Depending on the state that it is organized, an S corp might be subject to additional state taxes (franchise, income, etc.). Identification of specific state tax implications is beyond the scope of this article.
Payroll Tax - Although both types of entities will be subject to social security and medicare taxes, employee-owners of S corps will also be subject to any state and federal unemployment taxes. The taxes are not as high as the Federal Insurance Contribution (FICA) taxes, but still should factor into the decision.
References
https://www.irs.gov/pub/irs-pdf/f8832.pdf
https://www.irs.gov/pub/irs-pdf/f2553.pdf
Disclaimer
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.