Q What are S Corporations and How Do They Work?
The Corporation as an Entity.
A corporation is an entity. A corporation exists separate from its owner(s). A corporation can sue and be sued. A corporation has its own “social security number” in the form of its Employer Identification Number or EIN.
A corporation is owned by its shareholders. If you own stock in any corporation, you are an owner of that corporation. The shareholders elect the Board of Directors. The Board of Directors is in turn responsible for running the corporation on behalf of the shareholder-owners. The Board of Directors then elects and oversees the officers of the corporation that are responsible for the day-to-day operation of the corporation subject to the oversight of the Board of Directors.
Federal Insurance Contributions Act (FICA) Taxes
FICA is used to provide for the federal system of old age, survivors, disability and hospital insurance. The first three of these is funded by the Social Security system. Hospital insurance is funded by a Medicare tax. Both the corporation as employer and the employee(s), are required to pay FICA taxes on income earned as an employee of the corporation. The FICA tax rate is 7.65%. The breakdown of the 7.65% is 6.2% for the Social Security portion (old age, survivors and disability or OASDI) and 1.45% for the Medicare portion.
It is important to note that FICA taxes are paid by BOTH the corporation and the employee at the rate of 7.65%. Thus, the actual FICA tax rate is 15.3%. So, if you are the owner/shareholder of your own corporation, as well as the employee of your corporation, your income you’re your corporation will be subject to a 15.3% FICA tax. It should be noted that there are limits on the amount of OASDI taxes. However, that is beyond the scope of the discussion here. For now, you simply need to understand what FICA taxes are, the FICA tax rate and that they are paid by both the corporation and the employee(s) of the corporation.
Another tax that must be understood by all owners of corporations is the unemployment tax. IRS regulations require that all corporations have at least one employee. For most small business owner, they will end up being shareholder/owner, director, officer and employee of the corporation they own. Many states will require the owner of the corporation to carry unemployment insurance for the employee(s) of the corporation even if the only employee of the corporation is its owner. Even if the state of incorporation does not require unemployment insurance, the federal government will. What the small business owner needs to understand is that they will need to pay for unemployment insurance for themselves as the employee of their corporation. However, because they are the sole owner of the corporation, they cannot collect unemployment should the corporation they own ever fail and they find themselves without an income from their corporation.
C Corporations and S Corporations
A corporation can either be a “C” corporation or an “S” corporation. “C” and “S” refer to the subchapters of the Internal Revenue Code that govern the tax treatment of the two. All corporations are subchapter C corporations by default; when a corporation is formed it is a C corporation unless the shareholders of the corporation choose to be an S corporation instead by electing to become an S corporation in their minutes and filing the required form with the Internal Revenue Service. There are very significant differences between them.
An S corporation avoids the “double taxation” of a C corporation, but there are a number of rules that must be followed before a corporation can become an S corporation. For instance, an S corporation can have no more than 100 shareholders, and each shareholder must be an individual who is either a United States citizen or a Permanent Resident Alien.