If you’re familiar with the different types of businesses out there, you’ve probably heard something about an S Corporation 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 taxes for Social Security (12.4% of the first $132,900 of a taxpayer’s wages, tips, and net earnings) and Medicare (2.9% of the taxpayer’s wages, tips, and net earnings, without limit). Put more simply, self-employment taxes amount to 15.3% of the first $132,900 of net earnings and 2.9% of any additional 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 by the company 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, its owner would need to pay social security taxes equal to 12.4% of the first $132,900 of income (the maximum amount of income subject to social security taxes) and a 2.9% tax for Medicare on the entire $1,000,000, resulting in Social Security and Medicare taxes totaling $45,479.60, more than three 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 businesses — especially those with more than one owner or shareholder.

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.

Another sticking point with S Corporations is what the definition of a “reasonable salary” is. Clearly, if an S-Corp is making $1,000,000 and paying its owner $10 a year, that’s clearly an unreasonable salary and could be considered tax evasion, a crime punishable by up to $100,000 in fines and 5 years in prison. But what about the above example where the owner of an S-Corp is taking a $100,000 salary on $1,000,000 of income? Is 10% a reasonable salary? Probably not, but it could be, depending on the nature of the services the owner is providing. This issue is one of the most fiercely litigated in all of tax law, and there’s no cut and dry answer or formula to make these salary determinations.

Yet another 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.


  1. Hey, Ian. I have a question for you. I’ve been a freelance writer for over 10 years now. I was in the Gig economy long before it was ever called the Gig economy. I even got to the point for a while where I was paying subcontractors and filing my own employer 1099s with ridiculously basic employer software (https://www.1099-etc.com/). But in the last few years, my annual income has tapered off slightly–mostly just because I wasn’t able to work as much as normal. Anyway, I went to apply for a home loan, and the officer said it would be difficult to get credit for past earning income because, since the underwriters saw my income as “business income” the fact that is was declining was going to be a red flag. Do you know if this type of problem–needing to show growth to get a loan tied to your business income–is made better or worse by creating an S-corp? Thanks!

    1. Hello Alice,

      Thank you for that question! Unfortunately, financing is a tricky thing made more complicated by lenders’ own internal criteria for who they will or won’t give loans to. I’m happy to give you a bit of info on the financial implications of forming a Subchapter S Corporation compared to a sole proprietorship or a single-member LLC, and how using an S Corp might change the nature of your income. Before going into those financial implications, it’s first worth pointing out that if you’re currently set up as a sole proprietorship, you aren’t enjoying any of the liability protections of a distinct legal entity (like an LLC) and should certainly consider forming something to shield you and your assets from potential liability.

      As you’re now finding out, the income you receive as the owner of a less formal pass-through entity (e.g., sole proprietorship, single-member disregarded LLC, partnership, or multi-member LLC taxed as a partnership) is not considered income from wages or salary. Instead, it’s business income that passes through to you as an individual taxpayer. It may be taxed at the same rates as your other income, but the character of it is different and it can be subject to certain offsetting deductions that wouldn’t normally apply to your wages or salary. Unfortunately, these sorts of business entities can not pay wages or salary to their owners — the IRS will not recognize that income as wages or salary no matter what you call it, and you cannot issue a Form W-2 calling that income a salary. Similarly, most lenders will recognize that income as business income.

      Enter the humble Subchapter S Corporation (or “S Corp” for short). An S Corp has one defining feature that sets it apart from other pass-through entities: it must pay wages/a salary to its service-providing owners. Please note my use of the word “must” in that sentence, as it is perhaps the single greatest complication for owners of small S Corps with inconsistent income. While I talked at some length about the tax benefits of the S Corp in this very article, for your purposes, it’s worth noting that the salary the S Corp pays you would be considered wages or salary and would be reflected on a Form W-2 that the S Corp (or LLC taxed as one) must issue you each year. Any income received by the company in excess of that salary would be business income and would be separately reported by the S Corp on its tax return — and on yours. You would, in theory, be able to take your W-2 to the lender as evidence of wages/salary, which the lender may consider a more stable form of income. Or they may not, given your ownership of the company. Lenders are somewhat unpredictable.

      I hope this helps and wish you luck with your home loan application!

      – Ian

  2. I’m confused regarding the final paragraph in the section titled “S-Corps Can Provide Self-Employment Tax Savings”. For 2018 Social Security tax assessment (12.4% both sides) is only applicable to the first $128,400 right? Only Medicare tax is assessed on the entire amount (2.9% both sides). So the total SE tax would closer to $45k instead of the $153,000 stated in the article, right?

    Also, in your example the S Corp owner takes a salary of $100k and the remaining, roughly $900k, is taken in distribution. Is this 10% salary vs 90% distribution ratio going to raise some red flags with the IRS?

    1. Hi Jeremy,

      Those are both excellent questions, and you’re quite right about the income limits for Social Security taxes (though that limit is now $132,900 for 2019). I’ve re-run the numbers and updated the article. The difference is still significant, but not quite as significant as it would be if the entire net earnings were subject to self-employment tax at a 15.3% rate.

      Your second question is very interesting, very relevant to S Corp owners, and, not coincidentally, very difficult to answer. What is or isn’t a “reasonable salary” is one of the most frequently litigated issues in tax law. There is no clear and easy standard or formula to follow, and there no uniform standard applied by courts across the country in making a determination. They do consider many of the same circumstances, including the owner-employee’s qualifications, the nature, extent, and scope of the owner-employee’s work, the size and complexity of the company, the employee-owner’s salary in relation to the company’s income and distributions taken by owners, compensation for comparable work/positions, salaries paid to the company’s other employees, and the amount of compensation paid to the owner-employee in previous years. While a 90/10 ratio of distributions to salary doesn’t itself make a salary unreasonable, it would certainly raise a few flags and would necessitate a good explanation. A few other things to consider are that you typically can’t pay your other employees more than you, particularly if the work they’re doing is less vital or complex, and that you can’t take less in salary than your lifestyle generally requires — especially if you’re making up the difference in dividends/distributions.

      Thank you again.

      – Ian

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