S corporations are known for their tax savings, particularly their avoidance of double taxation and reduction of self-employment taxes. To determine whether an S corporation is right for your business, let’s start with explaining what an S corporation is and then walk through how to calculate S corp taxes.
What is an S corporation?
There are many different types of business structures. Some of these entities provide asset and liability protection and a host of tax benefits. S corporations are particularly tax advantageous in that the company can legally avoid double taxation and save owners money on self-employment taxes. Double taxation is when tax is paid twice on the same income. C corporations are subject to double taxation, where they pay corporate income tax on their income and then shareholders pay personal income tax on any dividends they receive.
An S corporation is not a separate type of business structure but rather a tax election made under Chapter S of the Internal Revenue Code. S corporations have the liability protection of a corporation, but the pass-through taxation treatment of an LLC.
Tax treatment of S corporation versus LLC
LLCs and S corporations both benefit from pass-through taxation. This means that the business’s income passes through to the owners and they only pay income tax once at the individual level. This differs from the double taxation treatment of C corporations, where the income is taxed twice. Since C corporations are treated as separate taxable entities, the corporation pays corporate income tax on its income, and shareholders pay personal income tax on their dividends.
Unlike LLCs, S corporation owners/shareholders can receive a “reasonable” salary (subject to the 15.3% self-employment tax), but any additional distributions to the owners are not subject to self-employment tax. This differs from an LLC where the entire amount of LLC profits is subject to self-employment tax.
How to form an S corporation
To form an S corporation, create either an LLC or corporation and make an election for “S” status on the IRS Form 2553. The IRS must receive the form within two and a half months of when you file your business formation documents with the appropriate state agency. Otherwise, you have to wait until the following year to get the S corporation tax status.
Corporations and LLCs already in existence can also make an S corporation election. In other words, if you do not elect S corporation tax treatment when you form your business, you can still do it at a later time.
The business entity filing for S corporation status must meet the following strict requirements:
- It can have only one class of stock;
- It must have fewer than 100 members; and
- Its owners/shareholders can only be U.S. citizens, resident aliens, certain trusts and estates, and tax-exempt organizations.
Corporations and partnerships cannot be owners of an S corporation.
LLC Formation Requirements
The formation requirements for an LLC are simple, which is why so many small businesses like them. You file Articles of Organization with the agency that governs business formation and compliance in your state along with a filing fee. There are few ownership restrictions or requirements, and you can run your business more your way. To keep your LLC in good standing, you will likely need to pay an annual or biennial filing fee to the state.
Corporation Formation Requirements
There are strict legal requirements when forming a corporation, and the corporation’s operations are subject to more stringent rules. While the laws vary based on each state, generally, a corporation must have at least one director, appoint officers, hold an organizational meeting, adopt corporate bylaws, and issue shares. Corporations are prohibited from owning shares in an S corporation but can be the underlying business structure of the S corporation.
A CPA can walk you through an LLC vs. C corp vs. S corp calculator to help you decide if S corporation status is right for your business.
How to calculate S corp taxes
Now that you know what an S corporation is, how it is taxed, and how to form one, we can go through the various components of calculating S corporation taxes.
Self-Employment Tax Calculator for S Corporations
All employees must pay taxes for Social Security and Medicare, even if they are self-employed. For most LLC owners, one of the biggest expenses they have is the self-employment tax, which is at 15.3% as of this writing. Self-employment taxes are taken before any deductions, which is a huge financial hit to an LLC. Your employment status determines the percentage you will pay. If you are an employee, you pay about 7.65% and your employer pays the other 7.65%. Those who are self-employed pay the entire 15.3%.
Herein lies the power of the S corporation. Taxes on an S corporation are based on the amount of income the S corporation has and the salary each owner takes. As we explain below, you may be able to reduce your tax bills by creating an S corporation for your business.
For example, if your S corporation makes $200,000 and a reasonable salary is $80,000, you will pay $12,240 (15.3% of $80,000) in self-employment taxes. The remaining $120,000 is not subject to self-employment tax but rather passes through to the owner as qualified business income (QBI). On the other hand, if you have an LLC that does not elect S corporation tax status, you will owe $30,600 (15.3% of $200,000) in self-employment taxes on the whole $200,000 profit. In the end, the S corporation is paying $18,360 less in self-employment taxes. Keep in mind that this is before any deductions are taken, so the S corporation will owe even less.
Salaries and Distributions
S corporation profits may be divided into two income groups: salaries and distributions.
Salaries paid to S corporation shareholders/employees must be “reasonable.” The IRS does not provide any guidance on what is “reasonable,” but you should consider the following factors:
- The employee’s duties and responsibilities;
- The employee’s training and experience;
- The amount of time contributed to the business;
- The amount of dividends paid to shareholders;
- Non-shareholders’ wages; and
- What similar businesses pay for comparable services.
The IRS imposes serious consequences for unreasonable salary amounts. IFor example, say an owner decides to pay themselves a lower than reasonable salary to classify profit as a distribution and pay less in taxes. The IRS has the power to step in and reclassify those distributions, as well as levy fines. Penalties may include payroll tax of up to 100% in addition to negligence penalties, which are 20% of the net understatement of tax.
Ultimately, unless you want to risk an audit by the IRS, don’t try to be sneaky and disguise your salary as a distribution.
Distributions made to S corporation owners are passed through onto their personal tax return, using a Schedule K-1, which are then taxed as ordinary income.
SECA vs. FICA
SECA (Self-Employed Contributions Act) requires self-employees to pay SECA taxes on their net earnings. SECA funds Social Security and Medicare. Self-employees pay the entire portion but can deduct half of the self-employment tax as a business expense.
FICA (Federal Insurance Contributions Act) requires employers to withhold taxes from employee earnings to fund Social Security and Medicare programs. These are commonly referred to as FICA taxes. The employer pays half (7.65%), and the employee pays the other half (7.65%) through withholdings in their paycheck. S corporation owners pay into FICA because they are not treated as self-employees by the IRS.
Since S corporations pay owners salaries just like a W-2 employee, they also owe payroll taxes such as unemployment insurance. Note that payroll costs are typically small and pale in comparison to self-employment taxes.
The amount of payroll your S corporation pays depends on the amount of your “reasonable salary.” Paying yourself a low salary and taking a high distribution will bring you the most savings. But remember, your salary must be “reasonable” or else you could face serious consequences.
S Corporation Tax Deductions
S corporations can take advantage of two powerful deductions — self-employment deduction and qualified business income (QBI) deduction.
With the self-employment deduction, the IRS allows S corporations to take a deduction for half the amount of self-employment tax paid.
The QBI deduction, also known as the Section 199A deduction, is for those who have pass-through income and is a deduction worth up to 20% of your taxable business income. QBI is essentially your business’s net profit, but only that which qualifies.The following income types are not QBI:
- Interest income,
- Capital gains and losses,
- Income earned outside of the U.S., and
- Certain payments made to business owners.
Note that the QBI deduction phases out for high earners who are in more lucrative fields, such as health, law, financial services, investing and investment management, accounting, consulting, actuarial science, etc.
State Franchise Taxes
State franchise taxes are the cost of doing business in a particular state. These are separate, and in addition to, state income taxes. S corporations are subject to state franchise taxes, but not all states have them. Franchise tax rates vary widely from state to state. S corporations must pay franchise tax to the state where they are incorporated.
Before electing S corporation status for your business, you should be aware of all the taxes your business may be subject to and determine whether electing S status is advantageous.
Try the ZenBusiness S corporation filing service
With the ZenBusiness S corporation filing service, we work with you to form the business of your dreams. As part of our service, we will file the necessary paperwork with the appropriate state agency to officially start your business. Our services include a name search, to ensure your business name is available for use, and expert filing support to help you throughout the entire process.
Note the ZenBusiness S corporation service only applies to those forming an LLC. We can’t help an established LLC file for S corporation status. When someone forms an LLC with us, we ask a series of questions to help them determine if the S corporation status would be best for them. We only offer this at the time of your LLC’s formation.
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Frequently Asked Questions
What are the tax benefits of an S corporation?
S corporations’ profits are not taxed twice (like C corporations), but rather the profits pass through to the owners and are taxed only at the personal income level.
Only a portion of the S corporation’s earnings are subject to self-employment taxes, as opposed to LLCs whose entire profits are taxed.
S corporations also get to take advantage of the self-employment tax deduction and the QBI deduction.
Should I pay myself a salary from my S corporation?
To take advantage of an S corporation’s tax benefits, consider paying yourself a “reasonable” salary from its profits. Check out sites like Glassdoor and Indeed to get an idea of what a reasonable salary may be for your job type.
The IRS points out that if most of the S corporation’s gross receipts and profits are coming from the services of a shareholder/employee, then the employee should be paid a reasonable salary.
Am I considered self-employed if I own an S corporation?
No, the IRS does not consider S corporation owners to be self-employed.
Do S corporations pay state income tax?
If the state requires businesses to pay income taxes, S corporations are no exception. They must also pay state sales taxes, franchise taxes, excise taxes, and gross receipt taxes, if applicable.
Do I have to make an S Corporation election at the state level?
Almost all states accept the federal election statement for state tax purposes. However, some do require a separate state election. This is why it’s important to know your state’s specific laws.
Yes; your S corporation has to file a federal income tax return (Form 1120-S) and a state income tax return to report all income, gains, losses, deductions, and credits. The S corporation must also file quarterly federal returns (Form 941).