Starting up a new business requires the owner or owners to make many decisions that will affect the tax treatment of profits and losses. Incorporating a business protects the personal assets of owners or shareholders from creditors or lawsuits.
There are two main types of corporations. All corporations start out as C corporations. Filing IRS Form 2553 is required to switch to an S corporation.
In both types of corporations, working owners must be on payroll with payroll taxes withheld. The salary needs to be reasonable or could be reclassified as a “draw” and subject to penalties and interest.
Both types of corporations require owners to keep all business records and bank accounts separate from personal transactions. Commingling of business and personal expenses could mean you fail to write off a proper business expense. It also makes responding to an IRS audit much more complicated.
Some of the differences get quite complicated. But a main difference is that a C Corporation files a standalone tax return and pays corporate taxes. The maximum corporate tax rate is 35 percent right now. For an S corporation the profit or loss flows over to an individual tax return. At the individual level, the top tax bracket is currently 39.6 percent. But if you are just getting started, an owner can offset wage income with corporate losses.
Doing the research to ensure the right type of entity is essential and must take into account tax issues. Setting up proper payroll reporting and withholding, for instance can avoid a later IRS audit and reclassification of money drawn from company accounts.
Source: Fox Business, “The Tax Differences Between a C Corporation and an S Corporation,” Bonnie Lee, July 25, 2014.