Of all the business entities someone could form, the S corporation is likely the most widely misunderstood. This is because the S corp is more tax designation than actual business entity. Both Limited Liability Companies (LLCs) and corporations can file to be taxed as an S corp. However, no state offers entrepreneurs the option to incorporate their business as an S corp; instead, those who want an S corp must file a form with the Internal Revenue Service (IRS). The S corp's somewhat foggy formation process is not the only thing that creates confusion. It is a common misconception that S corps will automatically save owners 15% on their taxes. To dispel any myths and explain more about S corporations, below you'll find a complete breakdown of what the S corp actually is, how to form one, and what you should know before you do.
What is an S Corporation?
The S corporation is a tax designation that a corporation or LLC can elect by filing a form with the IRS. The S corp tax designation allows corporations to avoid double taxation, as an S corp is a pass-through tax entity. That means the corporation itself is not taxed on its profits. The profits are passed onto the shareholders and are taxed as personal income, much the way an LLC is taxed. To truly appreciate the S corp's tax status, it's helpful to review how a corporation is taxed by default.
When someone forms a corporation, it is by default taxed as a C corporation. The money a C corp earns as net profit (the money left over after salaries and other expenses have been paid) will be taxed. Then, the net profit that is left over and not kept in the company will be distributed to the shareholders as dividends. On these dividends, the shareholders will have to pay personal income tax. Essentially, the net profit of a C corp is taxed twice —once as a corporation tax, then again as personal income to the shareholders. This is known as double taxation. S corp stat essentially rids a corporation of double taxation. Profits in an S corp pass directly to the shareholders and are not taxed at the corporate level. The S corp's earnings are taxed as the shareholder's personal income.
S Corporation Tax Benefits
As explained above, the S corp allows a corporation to avoid double taxation, but that fact doesn't completely capture the S corp's attractive features. LLCs, by default, are taxed in the same way as an S corp —profits in an LLC pass directly to the members and are taxed as personal income. S corps provide both LLCs and corporations a sometimes major tax benefit. S corps are allowed to pay out dividends to their shareholders. Dividends come from the net profits —what's left over after all expenses are paid. The beneficial part of S corp dividends, tax-wise, is that you are not required to pay the social security and medicare taxes on dividends, which is a savings of 15.3%. However, there is a catch: The IRS requires that owners of S corps are required pay themselves a wage, and the wage must be "reasonable compensation." That means you can't simply take all the S corp profit as a dividend —you must pay yourself a reasonable wage, which will be taxed as standard payroll wages. S corp owners can only reap the 15.3% tax savings on dividends.
Because S corps owners are required to pay themselves a salary and receive the tax benefit only on dividends, many businesses choose to wait to elect S corporation status until the income the company generates makes the tax designation worthwhile. As a general benchmark, many entrepreneurs will wait until their company starts clearing $50,000 of annual profit. Because of the expenses incurred through payroll services and general W2 wages, $50,000 is where things start to make fiscal sense. For example, if you took in $50,000 and paid yourself a $40,000 salary, you would have $10,000 left over as a dividend payment. At that point, the tax savings on the $10,000 dividend ($1,530) would likely cover payroll expenditures.
S Corporation Requirements
Although the S corp can present entrepreneurs with a wide range of advantages, it is not without its restrictions, which are listed below:
Requirements for LLCs and corporations seeking S Corporation tax status:
- LLCs and corporations that file to be taxed as an S corp must be domestic companies.
- Shareholders or members of S corps must be individuals, estates, or certain types of trusts; S corp shareholders cannot be partnerships, other corporations, or non-U.S. residents.
- S corps may only have one class of stock.
- An S corp may have no more than 100 shareholders (or members if an LLC).
- Certain types of corporations do not qualify: some financial institutions, insurance companies and domestic international sales corporations.
- You must file for the S corporation tax designation no later than two months and 15 days after the first day of the taxable year.
- All of a corporation's shareholders must consent to the S corp election.
- All shareholders or members must pay themselves a reasonable salary.
- Shareholders or members are directly responsible for the profits and losses according to their share of ownership.