In recent years S Corporations have been a great tax planning tools for self-employed taxpayers. They help reduce some of the self-employment (Social Security and Medicare) tax hit by allowing business owners to draw business profits (that are not subject to the self-employment tax). S Corporations do not pay income tax, since all income flows through to the owner. They are known as pass-through or flow-through entities.
C Corporations are separate entities which do incur income tax at the entity level. Any dividends to shareholders are also taxed as dividend income to the shareholder at the individual level. They are subject to the double taxation that most people have come to dread. A real small percentage of the businesses we encounter are C Corporations.
In most small to medium sized business, it has been a no brainer that S Corporations are a better option than C Corporations. However, the fiscal cliff tax law changes make this a much more complicated calculation. With all the flow-through income for S Corporation shareholders, higher income individuals can start to lose deductions, face surtaxes, and/or be subject to higher tax rates. The gist of this story is not to effortlessly assume that an S Corporation is always going to leave a taxpayer better off than a C Corporation.
By Adam Shay
Wilmington, NC CPA