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.
FAQs
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
What defines an S corporation? ›
An S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT).
What is an S corporation generally described as? ›
An S corporation is a corporation that elects to be taxed as a pass-through entity. Income, losses, deductions, and credits flow through to the shareholders, partners or members. They then report these items on their personal tax return. IRS approval is required for the S election status.
What is an S corp best for? ›
Asset protection. One major advantage of an S corporation is that it provides owners limited liability protection, regardless of its tax status. Limited liability protection means that the owners' personal assets are shielded from the claims of business creditors—whether the claims arise from contracts or litigation.
Which is true of an S corporation? ›
The correct answer is b) It cannot have more than one hundred shareholders. S corporations can only have one hundred shareholders or less. Only American citizens and residents can become shareholders of an S corporation. It is not a general partnership firm and can only be incorporated in the US.
Who can be an S corporation? ›
The S corp is available only to small businesses with 100 or fewer shareholders. It is an alternative to the limited liability company (LLC). Both S corps and LLCs are known as pass-through entities because they pay no corporate taxes. Instead, they pay their shareholders, who become responsible for the taxes due.
What is the difference between a Corp and S corp? ›
One of the primary differences is that C corporations are taxed at the corporate level with double taxation, while S corporations file IRS Form 1120S, and profits, losses, deductions, and credits pass through the entity level without corporate taxes.
What is an example of an S corp company? ›
As such, there are millions of S corporations in the United States, with some examples being retail stores, banks, car dealerships, and movie theaters.
Why is it called an S corporation? ›
S-corps are named from the subchapter of the Internal Revenue Code—subchapter “S”—under which the tax designation is spelled out. The most defining characteristic of an S-corp is its so-called “pass-through” tax structure.
Who is the owner of an S corp? ›
LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners). Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders. S corporations cannot be owned by corporations, LLCs, partnerships or many trusts.
An S corporation is a business structure and tax election available to private corporations, like LLCs or partnerships, that isn't subject to corporate income tax. In an S corp, profits pass through to the shareholders, who then pay taxes on those profits when filing their personal income taxes.
When should you become an S corp? ›
From a tax perspective, it makes sense to convert an LLC into an S-Corp, when the self-employment tax exceeds the tax burden faced by the S-Corp. In general, with around $40,000 net income you should consider converting to S-Corp.
Is S corp self-employed? ›
Some business owners wonder, "Am I considered self-employed if I own an S Corp?" Owners of S Corporations are "employed by" the S Corporation and receive a salary. This means that strictly speaking, you are not self-employed since you're considered an employee of the company.
What is the best definition of an S corporation? ›
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
How does S corp work? ›
An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts.
How do you tell if a corporation is an S corp? ›
Finance strategists has explained that, the corporation's classification can be found on the business returns form, which is annually filed. C corporations submit irs form 1120, whereas s corporations submit form 1120-s. Another way of knowing is to call the irs business helpline.
How is an S corp different from an LLC? ›
LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners). Non-U.S. citizens/residents can be members of LLCs; S corps may not have non-U.S. citizens/residents as shareholders. S corporations cannot be owned by corporations, LLCs, partnerships or many trusts.
How to tell if a company is an S corp or C corp? ›
Finance strategists has explained that, the corporation's classification can be found on the business returns form, which is annually filed. C corporations submit irs form 1120, whereas s corporations submit form 1120-s. Another way of knowing is to call the irs business helpline.
Which is a characteristic of an S corporation? ›
An S corporation is not a separate taxable entity. It files an information return but not an income tax return. The S corporation's income, losses, and other tax items pass through to its shareholders, who pay their share of the corporation's profits on their personal income tax return at the personal income tax rate.
Can a single member LLC be an S corp? ›
The default federal tax status for a single-member limited liability company (SMLLC) is disregarded entity. However, the owner of an SMLLC can elect to have the business taxed as either a traditional C corporation or as an S corporation. An S corporation is a special type of small, closely-held corporation.
