So you’ve decided to start a business – congratulations!  While there are many decisions to be made, one of the first tax questions is how best to organize your corporation, if you have decided to use the corporate form.  You may wonder, what is the difference in tax treatment between a C corporation and an S corporation? 

C corporations 

C corporations have not been a popular choice of entity due to “double taxation”. The taxable income of a C corporation is first subject to federal and state income tax (the current federal tax rate is 21%, and the Illinois tax rate is 9.5%). Dividend distributions to owners are then subject to tax again at the owners’ tax rate. Thus, the double layer of tax. The double tax cost is especially detrimental upon the sale of a company’s assets in an exit scenario, unless the gain from the sale qualifies for the Section 1202 exclusion http://craykaiser.com/section-1244/. 

S corporations 

S corporations are considered flow through entities. The taxable income of a corporation is not subject to federal tax (although some states, including Illinois assess a tax – Illinois’ S corporation tax rate is 1.5%). The income flows through to the owners and is subject to tax at the owners’ tax rate. 

For Example: 

Using a basic example, assume XYZ Corporation (an Illinois company owned by actively participating individuals) has $100,000 of 2023 taxable income for federal and state purposes. If XYZ were taxed as a C corporation, the company would be subject to $21,000 of federal tax and $9,500 of Illinois tax. If XYZ wants to distribute dividends to its individual owners, $69,500 would be available for distribution after payment of the corporate tax. Assuming the owners are subject to the 15% federal qualified dividend tax rate and the 4.95% Illinois tax rate, the tax on the dividend income would be $13,865 ($69,500 * 19.95%). The remaining cash of $55,635 would have been subject to an overall effective tax rate of about 44.37%. 

Now, let’s assume that XYZ Corporation elected to be taxed as an S corporation. The $100,000 of taxable income is first subject to the Illinois 1.5% replacement tax. The remaining $98,500 of taxable income flows through to the individual owners’ tax returns. Assuming the individuals are subject to the new highest individual tax rate of 37% (without consideration of the Qualified Business Income Deduction) and the 4.95% Illinois tax rate, the total tax payable would be $41,320, leaving remaining cash of $57,180.   

Although we did not include in our example the benefit of the state tax deduction for federal tax purposes, the math shows that overall an S corporation will provide a lower effective tax rate. 

The Qualified Business Income Deduction 

A further benefit of the S corporation is the effective tax savings from the Qualified Business Income (QBI) deduction. The 20% deduction is available to sole-proprietors, S corporations, and partnerships/LLC’s. Note that the deduction is not available to C corporations. 

QBI is defined as the ordinary (not investment) income less ordinary deductions from qualified trades or businesses. Wages earned as an employee are not considered QBI. 

The QBI deduction phases out for income from “specialized service” trades or businesses. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. There is also a phaseout based on wages paid in the business. A full discussion of the QBI is beyond the scope of this article; further, we believe regulations will be issued with clarification on this deduction. Click here to read more about the QBI deduction. 

Conclusion 

Although the 2023 tax rates continue to favor S corporations, tax rates are not the only consideration when determining how a corporation should elect to be taxed. As S corporations may not have corporations as shareholders, the types of owners may prohibit the use of S corporations. Additionally, if an S corporation has a loss, the ability to claim the flow through loss by owners may be limited due to insufficient tax basis. Finally, S corporations are not eligible for a Section 1202 gain exclusion. 

If you would like to talk through the corporate choice of entity with us, please contact us at (630) 953-4900. 

Please note that this blog is based on tax laws effective in December 2023, and may not contain later amendments. Please contact Cray Kaiser for most recent information.