As a business owner, reducing your yearly tax liability should be one of your top priorities. There are many ways to do this, but they can vary based on what kind of organizational structure you’ve decided to build your business as. In this article, we will be going over the S corporation tax election, which has various costs and benefits compared to LLCs, partnerships, and C corporations.

While there are some drawbacks, the S corporation structure is built in a way that usually produces the most tax savings compared to the rest.

What Is an S Corporation?

An S corporation or S Corp is a pass-through entity. This means that it allows taxable income, credits, deductions, and losses to pass directly to its shareholders. They then report this information on their personal tax returns and are assessed the tax at their individual rates.

An immediate benefit of this is that it avoids the double taxation of corporate income that occurs in other business structures.

S Corporation Qualification Requirements

To qualify for S Corp status, your business must meet the following criteria:

  • Be a domestic entity
  • Have no more than 100 shareholders who may only be individuals, certain trusts, or estates (no partnerships or C corporations can own shares)
  • Have only one class of stock
  • Not be operating an ineligible business (such as an insurance company, domestic international sales corporation, or certain financial institutions)

Similarities with Other Structures

Different legal entities come with different operating requirements, but in general, the S Corp structure does share some aspects with other tax elections. For example:

  • Limited Liability: S Corps provide shareholders with limited liability towards the debts of the business. Assets and liabilities are owned by the corporation itself, so shareholders are rarely held responsible for issues related to them. Just keep business and personal separate and you’ll have a lot less to worry about.

  • Corporate Formalities: You can also face similar formalities such as filing responsibilities, adopting bylaws, issuing stock, holding shareholder meetings, and filing annual reports, to name a few. These are required for most entities that operate above a sole proprietorship.

Administrative Costs

When operating as an S Corp, you’ll face more scrutiny from the IRS regarding how you pay your employees and shareholders. Instead of solely issuing profits to your shareholders through corporate distributions, you’ll need to administer W-2 payroll.

Each shareholder will need to pay payroll taxes such as FICA and unemployment taxes. Naturally, the business will also need to start paying payroll taxes as well. These payroll taxes will be paid each quarter, as well as annual taxes at the end of each year. The wages they earn will then be taxed under each shareholder’s individual tax rate.

Distribution Requirements

After payroll is paid, other corporate distributions are allowed to be given to shareholders. Some structures allow you to distribute these profits and losses however you please, but S Corps must distribute based solely on the percentage of shares each owner has control of.

Setup and Maintenance Costs

Creating an S Corp can also cost time and additional fees such as potential annual report fees and franchise taxes. On the upside, those fees are usually deductible as a necessary business expense, so paying them may reduce your yearly tax liability.

Growth Limitations

Finally, depending on how you want your business to expand, an S Corp does face limits on its ability to grow due to the limit on the number of allowable shareholders as well as the kinds of shareholders allowed.

Benefits of Operating an S Corporation

Thankfully, the benefits of operating an S corporation usually outweigh the costs:

Avoiding Double Taxation

We’ve already talked about how the S Corp election allows you to bypass the double taxation other corporations deal with. But by classifying the money they earn from the business’s payroll, shareholders can also avoid paying any additional self-employment tax.

Deductible Expenses

The money paid to employees as salary and the money paid by the business for yearly payroll taxes are counted as necessary expenses and are therefore deductible. So while you will be making more payments throughout the year, the total amount paid generally decreases when operating as an S Corp.

Tax-Free Dividends

Beyond standard payroll, S Corp shareholders can also receive corporate dividends that can remain completely tax-free if the dividends received don’t exceed the shareholder’s stock basis. The entire amount remains untaxed. And even if the dividends exceed the stock basis, the excess amount is taxed at a lower rate because it’s treated as a capital gain.

Qualified Business Income Deduction

Lastly, eligible S Corp shareholders are allowed to take an additional deduction of up to 20% of what’s considered net qualified business income.

Important Reminder

Remember, your potential S corporation exists at the discretion of the IRS. Establishing your business as an S Corp requires the filing of Form 2553, and if the IRS finds you in non-compliance, they have the power to remove your S election.

If you’re interested in setting up your business as an S Corp or if you have any other questions about the tax election, please reach out to our office and we will be happy to help.