Compass Newsletter - Articles

When to be an "S" Corporation

by Clark Williams
Fall 2001

All corporations have the option to be taxed as a "C" corporation or an "S" corporation. Both "C" and "S" corporations function the same way under state law, with shareholders, directors and officers. Both types of corporations provided limited liability protection to their owners. The difference is a special tax election filed with the IRS.

"C" Corporation vs. "S" Corporation

A "C" corporation, often called a "regular" corporation, pays its own income taxes based on its net taxable income at the end of each year. The federal tax rate on "C" corporations (other than personal service corporations) is 15% on the first $50,000 of taxable income, then 25% on the next $25,000 and 35% on the next $25,000. After $100,000 of net taxable income, the federal tax rate is 39%. Also, Oregon imposes an income tax on "C" corporations of a flat 6.6% of net income. For personal service corporations, the federal tax rate is a flat 35%. Coupled with the Oregon tax, the combined rate is 41.6%

On the other hand, an "S" corporation does not pay income taxes. Instead, the net income or loss of the "S" corporation is passed through to its shareholders in proportion to the shares owned by each shareholder. Thus, if the net income of an "S" corporation is $50,000 for any year, a shareholder owning 20% of the stock will report and pay tax on $10,000 of income in addition to his own individual income. This is true even if the $10,000 of income is retained in the corporation. In that case the shareholder will not pay tax on the $10,000 if it is distributed to him later. Further, if the income is distributed to the shareholder as a "dividend" instead of salary, then the shareholder will not pay FICA taxes on that income.

Thus, retained income of an "S" corporation is taxed just once, to the shareholders. Retained income of a "C" corporation may be taxed twice: first to the corporation when earned, and again when the income is paid to the shareholders upon eventual sale or liquidation of the corporation. However, the two taxes paid on "C" corporation income may still be less than one tax on "S" corporation income, particularly if the "C" corporation is in the 15% tax bracket. For a "C" corporation, a 15% tax now plus a 20% capital gains tax later may be less than the tax bracket of a high income "S" corporation shareholder.

On the other hand, the sale of a "C" corporate business with substantial appreciation or goodwill value will result in "double tax" and will be much more expensive than the "single tax" of an "S" corporation. If a "C" corporation elects to be an "S" corporation shortly before sale of the business, the "built-in gain" at the time of the election will still be subject to double tax. However, the "built-in gain" does not apply to a sale made more than 10 years after the "S" election.

Rules of Thumb

Based on these rules, you might consider making an "S" election for your "C" corporation under the following circumstances:

  • Your corporation consistently has annual net income, after salaries to shareholders, of $75,000 or more. In this range, the "C" corporation tax rate is approaching the shareholders' tax rates, and therefore it may be better to be an "S" corporation and pay tax just once.
  • You anticipate selling your business in the next 10 to 15 years and it has substantial goodwill value or appreciated property. The "S" election will limit or eliminate the double tax on sale.
  • You would like to lower your salary, and take the rest of your income in dividends, to save FICA taxes. This may be particularly appropriate for high income personal service corporations. But don't be too aggressive with this technique. Also recognize that lowering your salary may affect your retirement contribution.

On the other hand, you might rather stay a "C" corporation if you operate your business so as to leave less than $75,000 per year in the corporation to take advantage of the low corporate tax brackets. A "C" corporation grows and accumulates working capital more efficiently this way than can an "S" corporation.