What Is an S Corporation?Business Taxes
An S corporation is a corporation that has elected to pay no federal income tax on its income but rather pass through the income it earns, as well as other tax attributes, to its shareholders to report on their own tax returns.
Due to this passthrough treatment, S corporations, along with partnerships, are known as pass-through entities.
S Corporation Requirements
There are five requirements for a business to qualify as an S corporation.
|Entity Requirement||Must be a domestic corporation for tax purposes|
|Type of Shareholder Requirement||Only has individuals, certain trusts, and estates as shareholders|
|Number of Shareholders Requirement||Has no more than 100 shareholders|
|Stock Requirement||Has only one class of stock|
|Prohibited Corporations Requirement||Is not an insurance company, domestic international sales corporation, or a certain kind of financial institution|
How to Start an S Corporation
To start an S corporation, you must first form either an LLC or a corporation formed with the Secretary of State for your state.
Then, you must elect for your LLC or corporation to be treated as an S corporation for federal income tax purposes using Form 2553 in a timely fashion.
Electing S Corporation Status for a New LLC or Corporation
Then, this entity must submit to the IRS Form 2553, which is the S corporation election, within two months and 15 days of the date that you want the S corporation election to be in effect.
So let’s say you form an LLC on January 7 and you wish for it to be treated as an S corporation throughout the duration of its existence.
In this case, you must file Form 2553 some time between January 7 and March 21.
Electing S Corporation Status for an Existing LLC or Corporation
You can also make the election at any time during the tax year preceding the tax year you want the S corporation election to take effect, assuming your LLC or corporation existed then.
So if you have an existing LLC that has been treated as a sole proprietorship for federal income tax purposes — meaning that you have simply been reporting all items of income or loss on your Form 1040 Schedule C — and you want this LLC to be treated as an S corporation for tax purposes beginning on January 7 of next year, then you can file Form 2553 for this LLC at any time this year and all the way until March 21 of next year.
Late S Corporation Election
If you didn’t file your S corporation election in time, you may qualify for late S corporation election relief if you file within three years and 75 days of the date you want your business to be treated as an S corporation as well as meet other requirements.
How S Corporations Reduce Taxes
The number one reason why business owners elect S corporation status for their business entity is to save on taxes.
An S Corporation Doesn’t Let You Deduct More Expenses
However, many business owners misunderstand how an S corporation saves them on taxes.
Having an S corporation does not, for example, allow a business owner to deduct more expenses than they could have if they were still a sole proprietor reporting their business income and expenses on Schedule C; this is a misconception.
If you incurred an ordinary and necessary business expense with an S corporation, you can deduct this business expense somewhere on your Form 1120-S; similarly, if you have the same expense as a sole proprietor, you can deduct it on Schedule C.
An S Corporation Does Save You on Social Security and Medicare Taxes
However, electing for your business to be treated as an S corporation for federal income tax purposes can save you on the Social Security tax and the Medicare tax.
I’ll explain this with two examples, one involving a business netting $100,000 per year as a sole proprietor and the other as a business netting $100,000 per year as an S corporation.
Sole Proprietor With $100,000 in Net Business Income
Let’s say that you are a sole proprietor for tax purposes — either you have no entity or you have a single-member LLC that you haven’t elected S corporation status for — and that after your expenses your net business income is $100,000.
Assuming you’re single, take the standard deduction, and don’t have a deduction for health insurance, your taxable income would be $64,450.
|Reported on Your Form 1040||Amount|
|Form 1040, Line 8: Schedule C Income||$100,000|
|Form 1040, Line 10: Adjustment for 1/2 of Self-Employment Tax||- $7,000|
|Form 1040, Line 11: Adjusted Gross Income||= $93,000|
|Form 1040, Line 12: Standard Deduction (Single Filer)||- $12,550|
|Form 1040, Line 13: Qualified Business Income Deduction||- $16,000|
|Form 1040, Line 15: Taxable Income||= $64,450|
On this amount of taxable income, you’d end up paying about $10,000 in regular income taxes on this income assuming you have no other adjustments apart from the QBI deduction, which you get as a business owner.
In addition to this $10,000 in regular income tax liability, you will also be liable for self-employment tax — which is your Social Security tax and Medicare tax obligation as a small business owner — of about $14,000, leaving you with a total tax liability of about $24,000.
|Sole Proprietor Federal Tax Liability||Amount|
|Form 1040, Line 16: Regular Income Tax||$10,000|
|Form 1040, Line 23: Self-Employment Tax||$14,000|
|Total Federal Income, Social Security, and Medicare Taxes Paid||= $24,000|
S Corporation With $100,000 in Net Business Income
Now, what if you have an LLC and elect S corporation status for your LLC, netting the same $100,000 per year in their business as in the previous example?
In this case, you would have to pay yourself a reasonable salary out of your S corporation. Let’s say that in your industry, taking into account the services you provide to your own business, a reasonable salary for yourself is $40,000 per year.
In this case, you would only pay Social Security and Medicare on this $40,000. This would amount to about $6,000 in payroll taxes — $3,000 paid by your S corporation and $3,000 paid by you as an employee of your S corporation.
This would make your K-1 income from your S corporation $57,000.
|Reported on Your Form 1120-S||Amount|
|Net Business Income Before Shareholder-Employee Pay and Payroll Taxes||$100,000|
|Wages Paid to Shareholder-Employee||- $40,000|
|Payroll Taxes Paid by S Corporation||- $3,000|
|Net K-1 Income to Shareholder-Employee||= $57,000|
On your Form 1040 tax return, you would report your W-2 income from your S corporation of $40,000 as well as your S corporation’s net K-1 income of $57,000 for a total adjusted gross income of $97,000.
This amount less your $11,400 QBI deduction (calculated as 20% of your $57,000 K-1 income from your S corporation) and less your $12,550 standard deduction would give you taxable income of $73,050.
|Reported on Your Form 1040||Amount|
|Form 1040, Line 1: Wages||$40,000|
|Form 1040, Line 8: S Corporation K-1 Income to Shareholder-Employee||$57,000|
|Form 1040, Line 11: Adjusted Gross Income||= $97,000|
|Form 1040, Line 12: Standard Deduction (Single Filer)||- $12,550|
|Form 1040, Line 13: Qualified Business Income Deduction||- $11,400|
|Form 1040, Line 15: Taxable Income||= $73,050|
Your regular income tax on $73,050 would be $12,000.
So your total tax in the S corporation scenario is your $6,000 in payroll taxes plus $12,000 of regular income taxes for a total of $18,000.
That’s $6,000 less than your $24,000 in total tax liability in the sole proprietor scenario!
|S Corporation Scenario Total Tax Liability||Amount|
|Form 1040, Line 16: Regular Income Tax||$12,000|
|Payroll Taxes Paid by S Corporation||$3,000|
|Social Security and Medicare Tax Withheld From S Corporation Wages||$3,000|
|Total Federal Income, Social Security, and Medicare Taxes Paid||= $18,000|
When Not to Form an S Corporation
Although the previous example may make you want to run out and start an S Corporation, there are some situations where setting one up would not make sense.
1. You Have a Well-Paying Day Job
As shown in the previous example, the main way an S corporation can reduce its owner’s taxes is by reducing their self-employment tax liability.
With an S corporation, only the shareholder-employee’s wages are subject to the Social Security and Medicare taxes; the other earnings are not (though they are still subject to regular income tax on the shareholder-employee’s tax return).
The self-employment tax rates are 12.4% for the Social Security portion and 2.9% for the Medicare portion.
But taxpayers only pay the Social Security tax on combined wages and self-employment income up to the annually-set Social Security wage base, which is $142,800 in 2021
Wages and self-employment income in excess of this Social Security wage base amount are not subject to the Social Security tax.
So if you make at least $142,800 from your W-2 job, your only self-employment tax is the 2.9% Medicare portion.
In this scenario, the tax savings generated by electing S corporation status for your business may not outweigh the additional costs such as payroll processing fees and the cost to pay a CPA to prepare the S corporation tax return for you.
Also, your S corporation will have to withhold both Social Security and Medicare from your wages paid out of the S corporation, regardless of if your day job wages exceed the Social Security wage base.
As an employee, you can get a refund for excess Social Security taxes withheld when you do your Form 1040, but you can’t get back the S corporation’s portion of Social Security withholding on your wages.
This is not the case if you file as a sole proprietor, in which case you do not even have to pay the Social Security tax on your net business income in the first place if your day job employment income exceeds the Social Security wage base for the year.
2. You Want to Take Your Business Public
If you want to take your business public in the near future, an S corporation is probably not the right choice for you since an S corporation cannot have more than 100 shareholders, nor can they have shareholders other than individuals, certain trusts, and estates.
3. It Doesn’t Make Sense in Your State
Your state may have different rules for S corporations than the IRS does.
In fact, your state may prohibit individuals in your line of work from electing S corporation status for their business. For example, real estate brokers in California cannot run their business as an S corporation.
Also, your state may not offer the same tax benefits to S corporations for state income tax purposes that the federal government does for federal income tax purposes. For example, New York City-based S corporations will still be subject to the standard 8.85% corporate income tax rate.
4. The QBI Deduction Says Otherwise
As a sole proprietor, all of your net business income is eligible for the 20% qualified business income (QBI) deduction, subject to certain limitations.
With an S corporation, however, only your net S corporation income reported on your Schedule K-1 is eligible for the QBI deduction; wages paid to you from your S corporation are not eligible for this deduction.
This means that all else being equal, your QBI deduction will likely be higher as a sole proprietor than as the owner of an S corporation.
The higher your regular income tax rate, the more valuable your QBI deduction is and therefore the more this reduction in the QBI deduction is a drawback of electing S corporation status for your business in your particular situation.
This doesn’t mean that you shouldn’t elect S corporation status if you’re in a very high tax bracket; it’s just something else that should be considered when analyzing whether electing S corporation status for your business makes sense or not.
S Corporation Advantages
While an S corporation isn’t for every business owner, it does offer certain advantages that are appropriate in the right context.
Personally, I felt that the advantages of electing S corporation status for my LLC outweighed the disadvantages.
Reduction in Social Security and Medicare Tax Liability
As discussed above, electing S corporation status can reduce a business owner’s Social Security and Medicare tax liability.
Unlike C corporations — which pay tax on their own taxable income with the owner also paying taxes on any dividends received from the corporation — S corporations do not pay tax on their income for federal tax purposes.
S corporations, rather, pass through their net income and other tax attributes (such as tax credits) to their shareholders, and the shareholders report and pay tax on these items on their own tax returns.
Note that some states, such as California, do impose an S corporation-level income tax, so for state tax purposes, S corporation shareholders may be subject to double taxation.
Possible Reduction of Audit Risk
S corporations face lower IRS audit risks than sole proprietorships reporting on Schedule C.
That said, a popular audit trigger for S corporations is paying too low a salary to the shareholder-employee(s), so make sure that your salary paid out of your S corporation is considered reasonable by IRS standards.
S Corporation Disadvantages
Of course, as with any business and tax decision, the benefits of running your business as an S corporation for tax purposes must be weighed against the drawbacks.
Need to Determine Reasonable Compensation
S corporations are required to pay their shareholder-employees a reasonable salary.
Determining this amount can be tricky, though there are specialized services out there to help you determine your reasonable salary.
Also, putting yourself on payroll means incurring payroll costs to payroll processors such as to Gusto or ADP.
Additional Tax Return Filing
Your S corporation will need to file its own tax return. Hiring a CPA or other tax professional to do this will generally cost you at the very least $1,200.
Also, your individual tax situation may become more complicated as well now that you have to report the Schedule K-1 you receive from your S corporation.
Not Available to Certain Professionals in Some States
Some states have rules barring certain professionals from running their business as an S corporation in them.
For example, in several states, real estate brokers cannot run their business as an S corporation.
Possible Double Taxation for State Tax Purposes
Most states do not impose double taxation on S corporations, but some states do.
For example, California imposes a 1.5% income tax on S corporations with an $800 minimum tax, and New York City-based S corporations are subject to the standard 8.85% corporate income tax rate.
Everything Must Be Allocated Pro Rata
Unlike partnerships — which permit specially allocating tax items to their partners — S corporations must allocate all items of S corporation income, deductions, and credits to their shareholders exactly according to their ownership percentage.
Doing otherwise could cause the IRS to determine that the S corporation has more than one class of stock, which could cause the S corporation to be involuntarily terminated.
Should You Form an S Corporation?
Electing S corporation status has many tax implications that must be weighed against the potential drawbacks and additional costs.
If you would like professional assistance with determining whether an S corporation is right for you, email me at [email protected].
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.