Key Takeaways
- An S corp is a business structure that is legally a corporation but has pass-through capabilities to individuals.
- An S corp can potentially help business owners reduce their personal taxes.
- S corps can be a bit more complex than other business structures like LLCs.
Definition and Example of an S Corp
An S corp is a legal business structure that sits somewhere in the middle between traditional C corporations and LLCs. It gives business owners the ability to be treated as a corporation but also receive the benefits of pass-through income, losses, deductions, and credits.
The owner of a small consultancy, for example, may elect to become an S corp to gain some tax advantages while also having a business structure separate from themselves as an individual. Even freelancers might decide to form S corps.
How Does an S Corp Work?
An S corp works by having a business owner file for S corp status with the Internal Revenue Service (IRS) and potentially with relevant local tax jurisdictions. You have until two months and 15 days to file following the start of the tax year in which you wish for the S corp status to take effect.
Note
To qualify as an S corp, a company has to meet certain requirements such as being a domestic corporation and having a maximum of 100 shareholders.
Once a company has S corp status, the shareholders (who could just be one person, if you own 100% of your business) can then decide how best to distribute earnings for tax purposes. In many cases, an S corp owner will pay themselves a salary and then take some earnings as distributions. The salary would be taxed at ordinary income tax rates and incur payroll taxes, whereas the distributions would only incur income taxes.
The tricky part, however, is that it’s not exactly clear how much an S corp owner should take in salary versus distributions. If you tried to game the system by taking, say, $20,000 in salary and $80,000 in distributions so that you could minimize payroll taxes, you could run afoul of the IRS.
But there’s no exact formula. The IRS says that a salary must be “reasonable and appropriate.” From there, some factors that might go into determining what’s reasonable can include things like your “duties and responsibilities” and “payments to non-shareholder employees.”
Note
Speaking with a tax professional or related expert could be beneficial if you want to determine how much to take in salary versus distributions from an S corp.
Understanding Payroll/Self-Employment Taxes
Typically, a self-employed individual pays 15.3% in self-employment taxes to account for Social Security and Medicare taxes. This is separate from income tax rates. Those who work as employees typically pay half as much in payroll taxes (also known as FICA taxes), because the employer pays the other half. But a self-employed individual has to pay the full amount.
That’s where S corps come in because the earnings that pass through to the shareholders in the form of distributions—as opposed to wages—do not have to face these self-employment taxes. An LLC owner, however, would generally have to pay 15.3% in self-employment taxes for all pass-through earnings.
S Corp vs. C Corp vs. LLC
Like a C corporation, an S corp is a separate entity that has to follow certain filing rules and processes to operate legally. However, C corporation owners can essentially be taxed twice—once at the corporate level by paying corporate income tax, and again at the individual level, as business owners pay personal income tax on the money they receive from the corporation.
In contrast, S corps do not face this double taxation, at least at the federal level (some states treat S corps as C corps). S corp earnings can be passed through directly to shareholders, who report this income on their personal tax returns. In many ways, this is like an LLC.
However, a key difference between an LLC and S corps is that not all S corp business income has to be passed through as wages.
Note
Some S corp earnings can be passed through as distributions. These distributions can still be taxable at ordinary income tax rates, but they are generally exempt from employment taxes.
What Does an S Corp Mean for Individuals?
Individuals who own or are thinking of starting a business may want to consider whether forming an S corp is right for their situation. Doing so could be a good way to put some separation between yourself and the business while still getting some of the benefits of pass-through income. In fact, you might get even more tax benefits than if you operated under an LLC structure.
However, an S corp can be more complex than other business structures that individuals might consider, like a sole proprietorship or LLC. Take into account the effort needed to form and maintain an S corp, along with associated costs, such as if your state taxes S corps differently than some other business structures. Then, weigh that against the benefits, such as potentially paying less in FICA tax.
