Choosing the proper tax status for your business is very important. You definitely want to consult your CPA, legal team, and financial advisor to ensure you pick the right business setup and tax structure for your business.
What Is An S Corp?
An S corporation is a corporation that has elected “S corporation” as their tax status. Forming an S corp lets you enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or a partner in a partnership.
So… an S Corp is a business entity that has elected to pass its corporate income, losses, credits and deductions to its shareholders to include on their tax forms. It is not the same as an LLC, partnership, etc. those are considered business structures.
I often hear people say “well my business is an LLC, so we can’t be an S Corp,” but this is not a true statement. You can be an LLC that is taxed as an S Corp since an S Corp is not a business entity like an LLC. It’s an elected tax status.
Why Would You Want To Be An S Corp?
S Corp’s offer tax advantages while preserving ownership flexibility. With an S Corp, profits are passed through to shareholders personal returns so you aren’t double taxed like a C Corp.
With an S Corp, shareholders are paid a salary and the business pays them through payroll, which can be deducted as a business expense from the company’s taxable income. And here’s how they become advantageous from a tax standpoint – with an S Corp, you can pay yourself a reasonable salary (this number can vary) and this salary will be subject to self-employment taxes. Then you can take distributions above and beyond a reasonable salary (from the profit of the business) and these distributions will not be subject to self employment taxes. They will both be subject to state and federal income tax though.
So basically you can pay yourself a living salary and be subject to all the self employment taxes (12.4% Social Security and 2.9% for Medicare = 15.3%), but then take distributions outside of that and avoid that 15.3% tax. This can lead to huge tax savings.
Let’s go through an example to look at the tax savings between an S Corp and a Sole Proprietor.
Sole Proprietorship Example:
Self Employment Tax = $80,000 x .153 (self employment tax) = $12,240 just on the self employment tax part.
S Corp Example:
We will pay him $45,000 as his living salary and then take the other $35,000 of the profit out as a distribution.
Self Employment Tax = $45,000 x .153 (since it’s only on the salary part) = $6,885
This means with the S Corp, this person will save $5,355 on self employment taxes by not only paying himself through a salary, but by taking distributions. The savings come from not having to pay the 15.3% tax on distributions.
Now, many people hear this and say “well I should just pay myself entirely through distributions and take no salary.” And while this is a great idea, it does not work this way. You are required to pay yourself a living salary first before distributions can be made. This living salary can have a wide range, so make sure you do your research and pay yourself a fair salary.
Can I Be An S Corp If I Have An Owner Who Doesn’t Work In The Business?
In order to reap the benefits of an S Corp, all of your owners have to be paid a salary through the business. If you have a non involved owner (which I see often), you won’t want to pay them a reasonable salary if they aren’t doing work, just so you can take out the distributions – and you can’t just take distributions out for yourself and not the other owner(s). So you may be stuck. S Corps typically don’t make the most sense if you have a non involved owner who won’t be paid a salary.
Other Benefits Of An S Corp
- Reduced Taxable Gains – Selling your business can be part of your retirement strategy. An S Corp could have reduced taxable gains when the business is sold.
- Ability to write off start-up losses – Losses can be offset against your person taxes
Downsides of an S Corp
- Limited to one class of stock – not having the ability to issue different classes of stock leads to less control
- Less attractive to outside investors – Venture capitalists don’t want to see the pass-through tax setup or limit of 100 shareholders
Requirements To Setup an S Corp
- You may not have more than 100 shareholders
- Must be a domestic business entity
- The shareholders of the S Corp must be U.S. citizens or legal residents of the US
- Can only be one class of stock
If you meet these requirements and want to be an S Corp, then you need to make an S Corp election using the IRS form 2553 with the help of your team.
If you need help determining the right setup of your business, you can book a meeting with me here and I can help!
Disclaimer: Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining your individual situation you should consult your financial advisor. For all of the disclaimers, please see my disclaimer page.