A Texas S Corporation can be an attractive vehicle from a tax perspective because it offers flow-through taxation. This means that there’s no double taxation on the business income, as would be the case with a C Corporation, with only one level of tax being assessed at the shareholder level.
In addition, with an S Corp election in place, salaries paid to owner/shareholders who provide services to the corporation are not subject matter for payroll taxes (FICA and Medicare).
Factors to Consider Before Starting an S Corp
I. Do you plan to hire employees (shareholders)?
If so, and your state imposes an income tax on wages, you should consider whether the additional costs of payroll taxes will be less than what you would spend for a benefits package.
II. Where can your business locate?
Taxes vary from state to state; some states levy no corporate or personal income tax, while others have very high rates.
In addition, as with other types of corporations, there may be franchise fees imposed by the state in which you choose to incorporate.
III. What regulations apply to your industry?
Be sure that you are aware of any regulations before starting an S Corporation.
For example, if a banking institution is a significant part of your customers, but that type of corporation is forbidden by law in your state, you might want to consider another form of business entity.
IV. Will the S Corporation be conducting business across state lines, or is it possible that one or more out-of-state shareholders may hold stock?
If the latter applies, then be sure to check with your Secretary of State since you must file separate registration documents in each state where the corporation does business.
S Corporation Restrictions
The IRS has several restrictions on S Corporation eligibility, including:
1) The corporation may only have one class of stock. This means that all shareholders must be in the same position about their rights and preferences when receiving payments of dividends and proceeds from liquidation. For example, if some shareholders are entitled to a 5% cumulative dividend, and others get none, you cannot qualify for an S election
2) A shareholder’s ability to tax advantages benefits (such as amortization or depletion) is restricted by Internal Revenue Code”passive activity loss” rules and Texas Business Organizations Code; therefore, businesses such as oil and gas exploration might not be able to benefit from such losses. In addition, your business activities should not be illegal under any state or federal securities laws.
3) The Texas corporation must not have more than 100 shareholders (including persons counted as shareholders because their stock has been inherited). There may be an exception to this rule for certain family members whose ownership stems from the death of a shareholder (see ‘Family Attribution,’ below)
4) A particular type of trust known as an ‘ESBT’ cannot hold S Corp stock; however, an IRA can so long as it is stored in the name of a trustee and not in your name.
Why a Texas LLC Is the Best Structure for the S Corp Tax Status?
As a bonus, many states do not require tax partnerships or LLCs. Each state sets its own rules on forming Limited Liability Companies (LLCs), so be sure to check with your Secretary of State for legal advice.
As with S Corporations, profits and losses will flow through to each shareholder’s individual income tax return.
Steps for Forming an LLC and Electing S Corporation Status in Texas
The state of Texas requires a written operating agreement for any LLC wanting to elect S Corp status.
You will also need a federal Employer Identification Number (EIN) from the IRS to file election forms with the state.
- To form a Limited Liability Company, you must file Articles of Organization with the Secretary of State and pay a fee
- Choose your company’s name and appoint a registered agent.
- As soon as your LLC has been formed, make sure that an EIN is filed for it with the Internal Revenue Service
- Apply for exemption from Texas franchise tax by filing Form 05-120, Application for Exemption from Corporate License Tax, within four months after your business incorporation date but no later than December 31stof each year thereafter
- Complete Form 355-A, Application for Status as an S Corporation, and receive a Certificate of Formation
- Submit proof that your LLC is exempt from state franchise tax – this can be provided by sending a copy of Form 05-120 or through another means, such as the IRS determination letter for exemption.
Electing S Corp status requires notifying the state in writing.
Once this has been done, Texas will consider your small business corporation to have the same legal status as any other state S Corporation until you notify them otherwise.
Upon notification, you will be required to pay all applicable taxes in full at once rather than splitting it into installments throughout the year, unless you are current with all previously assessed taxes.
What are the benefits of an S corp?
- You may save on employment taxes
- S corporation shareholders are not considered employees for tax purposes
- Your losses may be limited
- The owners have their income and loss passed through to their personal returns
- Shareholders have the ability to perform a direct stock transfer in order to sell or buy shares of the business
- There may be additional state tax benefits, so check with your accountant.
Drawbacks of an S Corp
- If you and all your shareholders and employees are located in the same state, this could create a problem since Texas requires each separate division to obtain its own EIN. An exception to this rule can be made for those who live in bordering states (check with the Secretary of State if this applies to you).
- You must file as a corporation as well as an LLC
- There may be additional tax burdens or reporting requirements that do not apply to other business entities
- The owners have their income and loss passed through to their personal returns
How much does it cost to form an LLC?
A filing fee of $300. An additional franchise tax will be due annually, as well as necessary filings with the Texas Secretary of State and other departments.
The amount for both fees varies from county to county.
Types of Texas corporations:
- Close corporation – an LLC that elects to be taxed as a C corporation, which means they are taxed under Subchapter C of the Internal Revenue Code
- Business corporation – an organization formed for the purpose of conducting business and making money. It has no limit on how many shareholders it can have so long as at least one person is present at each annual meeting
- Professional corporation – An LLC that has registered with the Texas Secretary of State’s office to operate as a professional firm. These firms are usually limited to offering services in certain fields such as medicine, dentistry, law, architecture, engineering, real estate appraisal/consulting, veterinary medicine or counseling. The officers must also hold licenses within their specific professional field.
- Nonprofit corporation – an LLC that has filed articles of incorporation with the Secretary of State’s office to operate as a nonprofit institution. These companies can also be professional corporations if they fall within certain fields or charitable organizations
- For profit corporation – A corporation that has filed articles of incorporation with the Secretary of State’s office to be determined, but it is not for charitable or religious uses
Are taxes for LLCs and S corps the same?
Self-employment taxes are not considered when classifying an LLC or corporation; however, you will be required to pay employment taxes for your employees.
Employment tax rates vary depending on the amount of money an employee makes annually. The FICA rate is usually 7.65 percent (6.2 percent Social Security and 1.45 percent Medicare) for both employer and employee while federal unemployment insurance amounts to 6 percent for the former only. Income tax rates vary by state.
One great advantage of forming an LLC or electing S Corp status in Texas is that profits flow through to each shareholder’s individual income tax return, which means they are taxed at their appropriate level (so long as no other business entities exist).
As a result, companies do not have to pay double taxation.
What is a distribution?
A distribution is a type of payment made to a shareholder in return for their investment.
The ultimate goal of any corporation, LLC, or sole proprietorship is to make these distributions consistent and steady while increasing the company’s stock value through growth and other means.
What is pass-through taxation?
In a pass-through tax system, businesses have the ability to flow through their profits and losses directly to the individual returns of their shareholders.
This allows them to pay taxes on earnings based upon their personal level of income rather than charging them multiple levels of taxation at the corporate level for what would be small amounts of money.
Pass-through taxation can also work in favor of those who operate within sole proprietorships or single-member LLCs since there is no need to file another business return.
What is the S corp tax rate?
The S corp tax rate is the same as that of a sole proprietorship or single-member LLC, and it varies with the type of income passed through:
Short-term capital gains:
Greater than $400,000 in taxable income with a maximum federal tax rate of 35 percent for most taxpayers. The highest possible capital gain tax rate is 20 percent
Ordinary business income:
Lesser than $400,000 in taxable combined with a maximum federal rate of 39.6 percent (37 percent for most taxpayers) on any amount over that figure
Qualified dividends from another corporation:
A zero minimum amount means you will not be required to pay taxes on this source unless your taxable income after deductions comes out to below zero.
Otherwise, it is taxed at capital gains rates
Long-term capital gains:
Up to $500,000 in taxable income comes with a maximum federal tax rate of 20 percent. The highest possible tax rate for this kind of gain is 25 percent.
Can I still use my DBA name if I elect to be an S corp?
Even though you are filing your business as an S corp, you are still responsible for all state laws requiring a DBA.
This means that if your business name is not allowed under the rules in place in Texas, then you will either have to make any necessary changes or register under another name.
It also means that if your business exhibits any illegal activity in any way, it may result in action being taken against you by both the state and federal governments.
The process of electing S corp status in Texas is easy and affordable. In order to do so, you will have to meet the minimum number of shareholders allowed for this entity type as well as draft a compliance plan that outlines how your business will remain compliant with state laws regarding taxes and other regulatory subjects.
Once these steps are taken, you can sign all necessary paperwork and file it with the IRS along with a fee that covers your filing costs.
Your business must be established before you can take advantage of S corp tax rates since there is no way to retroactively elect corporate status.