S Corp Tax Advantages

An S corporation (S corp) is a tax classification and not a business structure that offers many tax advantages when elected by legal business structures such as a default LLC and a C corporation (C corp). The main S corporation tax advantages are pass-through taxation and as a result, additional tax savings for your business. 

S corps allow business owners to pay taxes on their individual tax returns as opposed to at the corporate level. After business expenses are paid, earnings, losses, credits, and deductions are passed down to the owner. The remaining distributions are not subject to self-employment taxes as long as the business owner has a reasonable salary.

Read our S Corp Tax Advantages guide to learn more about S corp tax advantages and potential tax savings for your business.

Recommended: If you’re a solopreneur making at least $60,000 with $20,000 in annual distributions, looking for potential tax savings, sign up with Collective for an all-in-one business solution that includes S corp formation, monthly accounting, and more.

What Is an S Corporation?

An S corporation (S corp) is a tax status under Chapter 1 of the Internal Revenue Service (IRS) code, also known as Subchapter S, elected by a limited liability company (LLC), a corporation, or a limited liability partnership (LLP). 

S corp status allows business owners to become salaried employees of a company, which grants them pass-through taxation as is the case with sole proprietorships, partnerships, and default LLCs. However, compared to these types of businesses, an S corp is not an actual business structure

An S corp tax classification allows its owners some additional tax benefits. Keep in mind that the IRS has specific requirements for businesses that elect to be taxed as an S corp, so make sure to know what they are and if you qualify before electing S corp status.

What Are S Corp Requirements?

If you’re considering forming an S corp, the IRS has S corp requirements you’ll have to meet. If all of the following apply, your business will be eligible to elect S corp status:

  • 100 shareholders or less
  • Must be a domestic LLC or corporation
  • Issue only one class of stock
  • Shareholders are US citizens or permanent resident aliens
  • Owned by private individuals

When you elect S corp status, make sure to stay on top of regulatory compliance and maintain detailed accounting records, especially regarding owner salaries. You can also have a professional service like Collective start your S corp and handle your accounting.

What Is a Reasonable Salary?

Before discussing S corp tax advantages, you’ll have to understand what is a reasonable salary and its importance if you’re planning on forming an S corp.

As a business owner, a reasonable salary means you’ll have to pay yourself an annual income reflecting your title, work experience, and duties as if you were a salaried employee of any other company within your industry. You can check out websites like Glassdoor or just search what type of salary your position would pay. 

Why Is a Reasonable Salary Important?

The importance of a reasonable salary is that the IRS will closely monitor how much you pay yourself to ensure that you’re not underpaying yourself to pay less on taxes. Failure to pay yourself a reasonable salary can lead to penalties and fines, the loss of your S corp status, along with all the advantages it provides — and even result in business dissolution.

What Are S Corp Tax Advantages and Other Benefits?

Small business owners prefer to elect S corp status when they are ready to formalize their business from an informal structure, such as a sole proprietorship or partnership, to an LLC or a corporation. Generally, starting an LLC is the preferred method to form an S corp since a C corporation (the default corporation tax status) requires more paperwork, costs, and regulatory oversight. 

The reason why most business owners convert their business into an S corporation is in part because they can save on self-employment taxes, among other perks.

What Are Self-Employment Taxes?

All businesses have to pay self-employment taxes, which consist of Social Security and Medicare taxes. If you have an employer, half of these taxes are paid for by the company that employs you. 

However, if you own your own business, it’s up to you to pay the full tax amount. Self-employment taxes cost a business around 15.3% at the current rate if you are self-employed. Entrepreneurship comes with enough costs, so why not minimize business expenses if you qualify for S corp tax savings?

Below are some S corp tax advantages, information on how S corps are taxed differently compared to other business types, along with other benefits:

Understanding S Corp Taxes

Once you start your LLC or corporation and elect S corp status for your business, you have the potential for tax savings. These depend on your company’s specific financial situation. 

We recommend forming an S corp if you can pay yourself a reasonable salary, make at least $60,000 a year, and have $20,000 in annual distributions. Net profits are the money left after company expenses are paid (e.g., physical location costs, marketing, salary, and any other business expenses). In an S corp, net profits are known as distributions, which are the earnings that remain.

For tax purposes, an S corp can be broken down into two tax portions, which are taxed differently: 

  1. Taxes Paid on Owner Salary Portion
    • Self-employment taxes
    • Income tax
  1. Taxes Paid on Distributions
    • Income tax only

An S corporation is able to save money on taxes on the distributions portion. This is because the distributions are only subject to income tax and not self-employment taxes, as is the case with all other pass-through entities.

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S corps also don’t pay corporate taxes, which makes them more enticing than a C corp to shareholders. Some states, such as California and New York, are the exception where an S corp pays some taxes at the corporate level.

Pass-Through Taxation

Many different types of business entities have pass-through taxation. These include sole proprietorships, partnerships, LLPs, and LLCs. In companies with pass-through taxation, the profits, distributions, credits, and losses are passed directly to the owner after business expenses are paid.

In the case of these pass-through entities, the owner(s) pay taxes on their total share of distributions at their individual tax rate on their personal income tax return. In other words, the owner(s) will pay the following taxes:

  • Self-employment taxes
  • Income tax
  • Distributions are based on ownership percentage of the company for multiple owners/shareholders

This means that if you’re a solopreneur with $20,000 in annual distributions after business expenses are paid, you’ll have to pay self-employment taxes and income tax on the full $20,000 amount. 

S Corp Pass-Through Taxation

Although an S corp has pass-through taxation, the self-employment taxes and income tax are only paid on the salary portion, resulting in tax savings on the distributions. In other words, you don’t have to pay self-employment taxes on the distributions under the S corp status, which saves you over 15%.

Limited Liability Protection

Since an S corporation can only be elected by formal business structures (LLCs and corporations), S corps come with limited liability protection by default. 

“Limited liability” means that your personal assets are protected if your business suffers a lawsuit or if creditors need to collect on your business’s outstanding debts. However, these third parties can still collect on the business’s assets (equipment, debts owed, etc.). To further protect your assets, make sure not to pierce the corporate veil.

How to Form an S Corporation

To form an S corporation, you’ll first have to start an LLC or a corporation. Next, you’ll elect to become an S corp by completing and filing Form 2553 from the IRS. You may be required to fill out other forms depending on your state. 

For example, if you form an S corp in New York City, you’ll need to fill out Form CT-6 with the New York Department of Taxation and Finance to be taxed as an S corp. You’ll also have to fulfill the New York LLC publication requirement.

We recommend that you start an LLC instead of a corporation since a corporation can negate some S corp benefits.

What’s the Difference Between an S Corp and a C Corp?

In contrast to an S corp, a default C corporation (C Corp) is taxed initially at the corporate level, currently at a 21% flat rate, which may change in the future. A C corp is known for its double taxation, meaning that after the business is taxed at the corporate rate, the shareholders are also taxed once they receive their distribution (the amount the owner receives after the business pays its taxes).

Here is how a C corporation is taxed:

  1. Corporate Level
    • Corporate Tax Rate: 21%
  1. Shareholder and/or Owner Level
    • Self-employment taxes on distributions
    • Income Tax on distributions
    • Distributions are taxed at the individual’s tax rate on personal tax return

This isn’t the case when a corporation elects S corp status. An S corp is essentially a corporate tax loophole as long as it makes financial sense not to have a C corp. It’s up to you to determine which tax classification is best for you based on the type of business you have and your company finances.

S Corp Disadvantages

Much like different types of businesses, S corps have advantages and disadvantages. We’ve already covered a lot of the advantages, which can be significant for a growing business. S corps have requirements and are subject to regulatory compliance that sole proprietorships, partnerships, and LLCs don’t have; LLCs have some regulatory compliance. 

S corps also have added costs such as formation costs and annual fees imposed on LLCs (e.g., annual or biennial reports) and corporations.

If you’re interested in owning a large corporation or taking your business public on the stock exchange, you may want to consider electing a C corporation instead. This is because you may not be able to attract the types of investors you’d need for major growth as a result of the limited number of shareholders allowed and one type of stock offering.

Overall, we still recommend that you start an LLC to elect S corp status over starting a corporation since it has the potential to maximize the tax savings for a small business under the right financial conditions. These savings will offset the S corporation costs (monthly bookkeeping, payroll) as well as help you save money. 

If you eventually outgrow an S corp status, you can always convert your business into a C corp or go back to a default LLC in case you decide to downsize your business.

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Looking for an all-in-one S corp LLC solution as a solopreneur? Let a professional service like Collective file your S corp, handle your monthly accounting, and manage your regulatory compliance.

FAQ

What is an S corp?

An S corp is a tax classification assigned by the IRS that allows a business owner to become a salaried employee. The salary portion pays self-employment taxes and income tax, while distributions are only subject to income tax.

Since S corp business owners don’t pay self-employment taxes on distributions, many small businesses elect this tax status for its potential tax savings.

How does an S corp save a business money?

An S corp isn’t taxed at the corporate level like C corps. Also, S corp owners save money on taxes since distributions are only subject to income tax and not self-employment tax.

Is an S corp a business structure?

No. An S corp is a tax classification that formal business structures, such as LLCs and corporations, elect for their tax benefits.

What is limited liability protection?

Limited liability protection means that the business is a separate entity from its owners. As such, the business owner’s personal assets (houses, cars, etc.) are protected in case the business is sued or debt collectors need to be paid. 

However, the owner must ensure to protect the company’s corporate veil.

Does an S corp have limited liability protection?

Yes, an S corp is either an LLC or a corporation by default that elect to be taxed as an S corp. Both an LLC and a corporation have limited liability protection since they are formal business structures.

What is pass-through taxation?

Pass-through taxation means that the business’s profits, credits, losses, and distributions are funneled directly to the owner/shareholder’s personal tax return to be taxed at their individual tax rate. In pass-through taxation (with a few exceptions such as New York City, California, and Texas), the business itself isn’t taxed. 

Is an S corp a pass-through taxation entity?

Yes, an S corp is a pass-through taxation entity with profits, credits, losses, and distributions passed down to the owner/shareholder. 

What is the difference between an S corp and a C corp?

Both S corp and C corp are tax classifications. However, there are a few differences between an S corp and a C corp. 

S Corp
An S corp is a pass-through tax status that an LLC or a corporation can elect. Owners are considered salaried employees for tax purposes, and distributions are only subject to paying income tax and not self-employment tax, saving the company money on taxes. 

S corps also have some IRS restrictions and requirements to qualify, including a maximum of 100 shareholders. Owners must be US citizens or permanent resident aliens. What’s more, owners must agree on S corp status and cannot be owners by other businesses, among other requirements.

There are some exceptions to this, but generally, S corps are not taxed at the business level.

C Corp
A C corp is known for double taxation. The business itself is taxed at a flat tax rate, and the shareholder distributions are then subject to self-employment taxes and income tax, increasing the tax burden. C corps don’t have the restrictions that S corps have but carry a heavier regulatory oversight than an S corp.

What are the S corp IRS requirements?

According to the IRS, the following are requirements for S corp status:

  • 100 shareholders or less
  • Must be a domestic LLC or corporation
  • Can issue only one class of stock
  • Shareholders are US citizens or permanent resident aliens
  • Owned by private individuals