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A S-Corporation May Help You Save a Lot in Taxes

If you’re familiar with the different types of businesses out there, you’ve probably heard something about S Corporations or “S-Corps”. Maybe a friend or colleague told you about some of their benefits, and maybe you’re even thinking about making one. Before you do, it’s important to understand why an S-Corp can be so beneficial to its owners — and why you still might not want to make one.

What is an S Corporation?

Many folks think the “S” in “S Corporation” stands for “Small Business”. While it’s true that S Corporations are fairly popular with small business owners even after the advent of limited liability companies, the “S” actually refers to Subchapter S of Chapter 1 of the Internal Revenue Code. Similarly, the “C” in “C Corporation” refers to Subchapter C. It’s important to note the difference, since we’ll be talking about both in this article.

To understand what an S Corporation is, you should first understand what a C Corporation is. C Corporations (or C-Corps) are businesses that are themselves distinct taxable entities. This means that when a C Corporation receives income, the C-Corp pays taxes on that income at the corporate rate and whatever is left over belongs to the C-Corp. The owner(s) of a C-Corp don’t see any money until the C-Corp pays it out to them in the form of a dividend, at which time the owner(s) would pay taxes on that same income at their personal rate(s). This is called double taxation. It’s pretty unique in the business world because almost every other type of business you can form has “pass-through” taxation. With pass-through entities (e.g., sole proprietorships, partnerships, and LLCs taxed as either), the profits and losses pass through the business to its owner(s). The business itself does not pay taxes on that income. The income is only taxed a single time, which, as you can imagine, usually results in some substantial tax savings. (For a better understanding of C Corporations and why you might still consider one, see our other article: Return of the C Corporation)

To answer the question at hand, an S Corporation is, at its core, a C Corporation with pass-through taxation and some unique limitations. As with a sole proprietorship or a partnership, the profits and losses of an S Corporation pass right through to its owners — the S Corporation itself isn’t subject to income tax. This is true of many other pass-through entities (e.g. sole proprietorships, partnerships, and certain LLCs), but S Corporations have one big advantage that other pass-through entities don’t.

S-Corps Can Provide Self-Employment Tax Savings

One of the biggest reasons a business owner chooses to form an S Corporation (or an LLC taxed as one) is the reprieve from self-employment taxes. As the owner of a sole proprietorship, partnership, or LLC taxed as either, you cannot be employed by your own company in the traditional sense. When your company receives taxable income, it passes through to you as the owner and you must pay tax on it — not simply income tax, but self-employment tax as well. Self-employment tax consists of both the employer’s and employee’s portion of Social Security and Medicare taxes. These taxes together amount to 15.3% of your net earnings. This is in addition to any federal, state, and local income taxes and franchise taxes you might be subject to. As you can imagine, it all adds up pretty quickly.

By contrast, if you own an S Corporation, you can and, generally speaking, must be employed by your company if you’re providing any services to the company, for its benefit, or on its behalf — and the company must pay you a reasonable salary in exchange. This typically applies to all but the most passive of owners (i.e. silent partners/shareholders). When an S-Corp owner is employed by their company, the company pays the employer portion of the Social Security and Medicare taxes (often referred to as “FICA” taxes) and the owner pays the employee portion as a withholding from their “reasonable salary”. Any income of the company in excess of the salary still pass through to the owner, but none of that excess income is subject to self-employment tax.

To illustrate this scenario, let’s say you start a small marketing company. After a few years, it’s doing pretty well financially, the company is making $1,000,000 in net earnings and you’re paying yourself a reasonable salary of $100,000 per year. The S Corp would pay you $100,000 and would also pay its share of the FICA taxes totaling 7.65% of the salary it paid you — in this case, $7,650. As the recipient of the salary, you would pay the employee’s portion of these taxes through normal payroll deductions also equaling 7.65% (or $7,650). The total amount of Social Security and Medicare taxes paid in this scenario is 15.3% of the $100,000 salary, or $15,300, of which $7,650 was paid on top of the $100,000 salary. That leaves the company with $892,350 of net earnings that pass through to the owner without the owner needing to pay any additional self-employment taxes.

Compare this to the owner of a different type of pass-through entity, such as a disregarded single-member LLC. The LLC in this instance cannot pay its owner a salary. If it were to receive $1,000,000 in net earnings in a year, it would need to pay the 15.3% self-employment tax on the whole $1,000,000, resulting in Social Security and Medicare taxes totaling $153,000, or ten times as much as the owner of an S Corporation in a similar situation. The cost savings are pretty apparent, and they make S Corporations a pretty appealing bargain for many small to mid-sized business owners.

S-Corps are Complicated, and Require Significantly More Paperwork

While the tax savings can be pretty sizable, an S-Corp has a few notable drawbacks that you should be aware of when choosing your business entity. First, there are limits on who can form an S Corporation (or own an LLC electing to be taxed as one). An S-Corp may have no more than 100 shareholders and cannot be owned by another corporation, a partnership, or non-resident alien. Those limits might seem simple enough at first, but they can throw a real wrench into the process of bringing on investors or selling your company one day.

Perhaps a more immediate reason many folks avoid S Corporations is their complexity. If you own a disregarded single-member LLC, the profits and losses pass through to you automatically — you just report them on your personal Form 1040 every year. If you have an S-Corp (or an LLC taxed as one), the company will typically need to file a Form 1120S (U.S. Income Tax Return for an S Corporation), a Form 1120S Schedule K-1 (Shareholder’s Share of Income, Deductions, Credits, etc.), Form 940 (Employer’s Annual Federal Unemployment Tax Return), Form 941 (Employer’s Quarterly Federal Tax Return), and you as an owner/shareholder will typically need to file a Form 1040ES quarterly for your estimated payments in addition to your Form 1040 every year. (For more on how pass-through entities deal with income taxes, see our other article: Do I have to file income taxes if I have a pass-through entity?)

And that’s just for federal taxes. State taxation of S Corporations can be tricky and will often involve franchise taxes as a roundabout way to tax the value of S Corporations without taxing “income”. Add in some annual reports and corporate formalities for good measure, and the end result is an administrative nightmare for many people.

What’s the takeaway?

Forming an S Corporation (or an LLC taxed as one) might be a good idea if your company can afford to pay its owners a regular, reasonable salary and still have enough earnings left over to result in a big self-employment tax savings. Some business owners might prefer to avoid the complexity and the hassle of an S-Corp, especially if the business is starting out small or if the owner doesn’t anticipate the business growing significantly. Some business owners choose to convert to an S Corporation a few years after the business is formed — a process that is often difficult but typically manageable. If you’re not sure what business entity is right for you, your best bet would be to consult with a knowledgeable business or tax professional who can walk you through the “Pros and Cons” of each of your choices.

Here at Law 4 Small Business, we specialize in helping people start business of all different shapes and sizes. Give us a call today and let us help you find the right path for you and your business.

Law 4 Small Business, P.C. (L4SB). A little law now can save a lot later. A Slingshot company.

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