What is an S corporation? The Beginner’s Guide
An S-corp is a federal tax name created by Congress so that small businesses can receive favorable tax benefits. An LLC (Limited Liability Company) or corporation can elect for S corporation status in the IRS, but there are some requirements. To become an S-corp, you must set up payroll, have fewer than 100 shareholders, and issue only one class of stock.
How does an S corporation work?
Owners cannot register their business as an S corporation. They must first register the business as an LLC or corporation in the state where they primarily operate. Once registered, they need to file IRS Form 2553 with the IRS to indicate that they want the business to become an S corporation: this process is called “election for S corporation status.”
The main reason a business owner would want to choose their LLC or corporation as an S-corp is to save money on taxes. An LLC avoids paying self-employment taxes with a dividend payment. A corporation avoids the 21% tax at the corporate level.
The main disadvantage of an S corporation is the additional maintenance. Someone with a simple LLC will have to set up payroll and pay payroll taxes in order to file taxes as an S-corp. There is also the possibility that you will save little or no money on taxes, which we will discuss below.
How to save money on taxes with an S-Corp
As an LLC, you will pay less in self-employment taxes. Typically, as a business owner, you will pay 15.3% of net profit for Social Security and Medicare taxes. For example, if your business earns $80,000 in net income, you will owe $12,240 ($80K x 15.3%) in self-employment taxes.
If you choose S-corp status, you only pay self-employment taxes on “reasonable” wages for the work you do as an owner. I understand it can be challenging to estimate a S Corp Reasonable Salary as a business owner, but that’s how the IRS frames it. So, imagine you are paying someone to do your job, how much would you pay them?
For our example, let’s say a reasonable salary for your job is $50,000 a year. Self-employment tax on $50,000 is $7,650 ($50K x 15.3%). What about self-employment taxes on the other $30,000 in net earnings? There are none. You don’t pay self-employment taxes on that profit, because it’s paid as a dividend, saving $4,590 in taxes. As a corporation, if you choose S-corp (rather than C-corp) tax status, then you avoid the 21% corporation tax on profits.
The tax savings for both LLCs and corporations can be huge.
Who is an S-Corp not suitable for?
If the tax advantages of S corporations are so beneficial, why would anyone choose to pay taxes as an LLC or C corporation?
As an LLC, if you don’t earn more in net profits than a reasonable salary would be, then you won’t save more money on taxes. While you can technically choose S-corp status, the additional paperwork would not result in tax savings. Additionally, there are factors that force corporations to pay taxes as a C corporation versus an S corporation. These include having more than 100 shareholders, issuing more than one class of stock, and having foreign owners.
Who is an S Corporation Right For?
Generally speaking, smaller businesses that earn net income in addition to owner pay can benefit from choosing the S-corp tax designation. Here are some scenarios where tax status could be advantageous:
- Freelancer: A freelancer, such as a graphic designer or digital marketer, who earns more than is typical in the market.
- Consultant – A consultant who earns revenue as a percentage of the project cost or as a percentage of revenue growth.
- Retail Business Owner – The owner of a store, such as a hair salon or boutique, who makes more profit than a Reasonable Salary for S Corp Owners a store manager.
- Experienced professional-based business: a doctor, lawyer, or accounting firm that earns more than a typical hourly rate for their profession
- Corporations with fewer than 100 shareholders: A corporation with fewer than 100 shareholders can avoid the 21% corporate tax rate.