Whether you’re forming a new company or contemplating changing your business structure, the decision between opting for an S Corporation or an LLC for tax purposes is a crucial one. An S Corp often has specific tax and ownership benefits, making it the better choice for many small businesses.
So what is an S Corporation, and what are the advantages and disadvantages of forming your business as one? Read on to learn all about S Corporations.
What is an S Corporation?
An S Corp or S Corporation can start as an LLC or C Corp and then file to be taxed as an S Corp 1. S Corporations get their names from the election to be taxed under Subchapter S of the Internal Revenue Code.
An S Corp is a “pass-through entity,” meaning the company’s income, losses, deductions, and credits pass through to the owners. The S Corporation pays no taxes; the owners are paid and responsible for the taxes due.
Whereas an LLC has members who have a formal agreement among them, an S Corporation may have up to 100 shareholders who must be individuals, certain tax-exempt organizations, or specific trusts and estates.
Pass-through entities differ from C Corporations, which pay taxes on their earnings, and investors pay taxes on their profits. As a pass-through entity, an S Corp avoids that double taxation.
Tax benefits aside, an S Corporation’s formation is similar to a C Corporation in that it is governed under the same state corporation laws, is for-profit, and offers similar ownership and management advantages. Additionally, an S Corp offers liability protection equal to a C Corp.
Lastly, an S Corp requires more formalities than an LLC because it must observe the same formalities as a C Corp. Those practices include having a board of directors, shareholders’ meetings, and corporate bylaws. Minutes must be kept of company meetings that are significant in nature.
Benefits of an S Corporation Structure
One of the primary advantages of an S Corp is the tax benefit it offers to its owners, as they are not required to pay self-employment tax on the distributions they receive. These distributions are typically made after the owners have received reasonable compensation or a W-2 salary 2.
Here’s how this benefit works: Owners who actively work within the S Corporation usually receive a W-2 salary, which not only provides them with a regular income but also serves as a tax deduction for the business3. Moreover, if these owners have been paid “reasonable compensation” for their services, they can then receive a share of the company’s profits in the form of distributions. This strategic distribution of profits helps lower their self-employment tax liability significantly4.
Typically, self-employed individuals are obligated to pay both the employer and employee’s portions of FICA taxes on total profits, which amounts to a total of 15.3 percent. However, S Corporation owners can mitigate this tax burden by structuring their income in a way that minimizes their self-employment tax liability, making the S Corporation structure a tax-efficient choice for business owners5. However, owners are still required to pay reasonable compensation to shareholder-employees, which is subject to employment taxes.
A significant benefit of an S Corporation is the tax benefit of the company not having to pay federal taxes and therefore not being subject to double taxation. Tax benefits also carry over to the owners who provide services to the S Corporation. If owners work within the business, they typically receive a W-2 salary which is a tax deduction for the business.
Generally, those who own an S Corp and actively work in the business only pay self-employment tax on their reasonable compensation amount. Additionally, if the shareholder’s distributions exceed their stock basis, they are taxed as capital gains, which is a rate considerably lower than regular income tax6. Capital gains are generally subject to a considerably lower tax rate than regular income, providing another potential tax advantage for S Corporation shareholders7. This feature further enhances the appeal of the S Corporation structure for business owners seeking to optimize their tax obligations.
How is an S Corporation Taxed by the IRS?
As previously mentioned, S Corporations don’t pay federal corporate taxes. Instead, the shareholders split the income or losses equal to their stock ownership, and the profit or loss is reported on their personal tax returns on an IRS Schedule K-1. Due to this tax treatment, S Corporations avoid the double taxation to which C Corporations are subject.
Even though they are not taxed, the S Corporation does file a tax return on IRS form 1120-S accompanied by the same K-1s sent to each owner. The 1120s tells the IRS the income, losses, distributions, and dividends that have been passed to the owners by the company8.
While C Corporations file quarterly taxes, S Corporations only file yearly, and the 1120-S form is much simpler than C Corporations tax forms. It is due by the 15th day of March, so long as an extension has not been filed.
While an S Corporation typically files taxes annually, it is important to note that shareholders may be required to make quarterly estimated tax payments. These payments are typically made by individuals receiving pass-through income and are only necessary if their tax liability exceeds the amount withheld from their W-2 income. It’s worth mentioning that these estimated tax payments not only cover estimated income tax but also other taxes like the alternative minimum tax, if applicable9.
Tax Benefits of Filing as an S Corp
C corp owners are subject to double taxation; the corporate taxes and then personal taxes on any distributions or dividends made. An S Corp passes income through to the owners, so they are only taxed once10.
S Corp income benefits from all of the deductions of any C Corp, meaning things like business losses, vehicle expenses, employee benefits, rent, advertising, and depreciation reduce the company’s taxable income before that income (or loss) is passed through to the owners.
S Corp owners who work in the business and pay themselves a reasonable salary will pay Social Security and Medicare taxes on their salary. Still, additional company profits taken as distributions will not be subject to self-employment taxes as they would be with an LLC. This avoidance of self-employment taxes is a considerable saving as self-employment taxes are taxed as both the employee contribution to Social Security and Medicare plus what would be the equal company contribution, equating to a 15.3% tax rate11.
Avoiding that 15.3% self-employment tax rate is a massive benefit for S Corp owners, but they must show the IRS they are paying themselves reasonable compensation.
RCReports is Here To Help!
Choosing an S Corporation (S Corp) can offer significant tax advantages to business owners. S Corps excel at eliminating double taxation and allowing owners to reduce their taxable earnings through deductions before passing them on to shareholders.
This can help owners avoid substantial self-employment taxes, making S Corps an attractive option for many small businesses looking to optimize their tax structure.
However, it’s crucial to recognize that an S Corp may not be the right choice for every business. Business owners should consult with their accountants to determine the optimal time to transition to an S Corp. While the potential tax benefits are compelling, it’s important to consider the additional administrative costs associated with S Corps, such as payroll and the need for a separate business tax return.
To assist in making this critical decision, the RCReports Entity Planner offers a comprehensive 10-year outlook on your business’s financial landscape. This tool takes into account all relevant factors, allowing you to make the best-informed decision for your business’s financial future.
Owners actively involved in the business should ensure they pay themselves a fair and appropriate salary, determined by the services they perform for the business and their role within it. This practice is essential to avoid any issues with the IRS. Calculating reasonable compensation for owners is a crucial S Corp activity, and seeking the help of experts can greatly assist in this process and potentially contribute to a smoother experience should an IRS audit occur.
Accountants, owners, and business valuators use RCReports for reasonable compensation calculations and reports that hold up to IRS scrutiny and litigation.
To explore the benefits of an S Corporation further, consider exploring the RCReports Entity Planner, a valuable tool that provides a 10-year financial outlook.
References
1. Internal Revenue Service. (2023, February 7). S Corporations | Internal Revenue
Service. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
2. Internal Revenue Service. (2008, August 25). Wage Compensation for S Corporation Officers. IR-2003- (irs.gov)
“The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go to ethe shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate. There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.”
3. S Corporation Compensation and medical insurance issues | Internal Revenue
Service. (2023, June 26). https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues
“The instructions to the Form 1120-S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
4. TurboTax. (2023, June 2). How an S-Corp can Reduce your Self-Employment
Taxes. Intuit TurboTax. https://turbotax.intuit.com/tax-tips/small-business-taxes/how-an-s-corp-can-reduce-your-self-employment-taxes/L4abUcaRn
“If you organize your business as an S-corporation, you can classify some of your income as salary and some as a distribution. You’ll still be liable for self-employment taxes on the salary portion of your income, but you’ll just pay ordinary income tax on the distribution portion. Depending on how you divide your income, you could save a substantial amount of self-employment taxes just by converting to an S-corporation.”
5. Internal Revenue Service. (2023b, August 3). Self-Employment Tax (Social
Security and Medicare taxes) | Internal Revenue Service. https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes
6. S Corp Distributions in Excess Of Basis: Everything You Need to Know. (2020,
October 15). UpCounsel. https://www.upcounsel.com/s-corp-distributions-in-excess-of-basis
“According to Section 1.1368-1(c), a two-tier approach has to be used to tax a distribution from an S corp without accumulated earnings and profits. Firstly, the distribution is regarded as a tax-free reduction in the stock basis of the shareholder. Secondly, a distribution that exceeds the stock basis of the shareholder will be regarded as gain from selling or exchanging the underlying stock. In an S corporation without accumulated earnings and profits, the accumulated adjustments account is totally irrelevant in the determination of the taxability of distributions. Instead, the stock basis of the shareholder is the only attribute of consequence.”
7. Orem, T., & Parys, S. (2023). Capital Gains tax: 2022-2023 tax rates and
calculator. NerdWallet. https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates
“A capital gains tax is a tax on the profit from the sale of an asset. How the capital gain is taxed depends on filing status, taxable income and how long the asset was owned before selling. The capital gains tax rate is 0%, 15% or 20% on most assets held for longer than a year. Capital gains taxes on assets held for a year or less correspond to ordinary income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% or 37%.
Capital gains taxes apply to the sale of capital assets for profit. This can include investments such as stocks, bonds, cryptocurrency, real estate, cars, boats and other tangible items.”
8. About Form 1120-S, U.S. income tax return for an S Corporation | Internal
Revenue Service. (n.d.). https://www.irs.gov/forms-pubs/about-form-1120-s
9. Estimated Taxes | Internal Revenue Service. (n.d.).
https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes
10. Internal Revenue Service. (2023, February 7). S Corporations | Internal Revenue
Service. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
11. Internal Revenue Service. (2023c, August 3). Self-Employment Tax (Social
Security and Medicare taxes) | Internal Revenue Service. https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes
“The self-employment tax rate is 15.3%.”
