If you are a small business owner who wants to lower your tax bills, setting up an S-Corporation (S-Corp) might be a great idea. An S-Corp allows you to split your earnings between a salary and other types of payments called distributions. This can help you save a lot of money on taxes, especially on Social Security and Medicare.
In this article, we will explain how an S-Corp works, how it can help you save on taxes, and what you need to do to safeguard your S-Corp status. We'll also cover the benefits and challenges of using an S-Corp so you can decide if it's the right fit for your business.
An S-Corporation (S-Corp) is a type of business that combines the legal protections of a regular corporation with the tax benefits of a smaller business. Like a C-Corporation, an S-Corp protects its owners (also called shareholders) from being personally responsible for business debts. That means if the company owes money, creditors can't come after your personal assets like your house or car.
But unlike C-Corps, S-Corps do not pay corporate income taxes at the Federal level. Instead, the company's profits and losses are passed on to the owners, who report them on their personal tax returns. This way, S-Corps avoid being taxed twice, which usually happens with C-Corps.
S-Corps are popular with small business owners because they offer good tax savings while still giving liability protection. But to get the most out of an S-Corp, you need to understand the tax rules and how to manage your income properly.
Even though the S-Corp pays no Federal income tax, there may be a State franchise tax, business tax, or fee imposed by the State or States that you are registered to do business in.
(Please note, that at Make Taxes Fair we are not attorneys and this information is educational in nature. We encourage you to consult an attorney regarding the ins and outs of what legal protection an entity such as an LLC or Corporation may or may not afford you.)
S-Corporations must file a special tax form called Form 1120-S. This form is used to report all of the company’s income and expenses. Each shareholder also receives a document called a Schedule K-1.
The K-1 shows each person's share of the company's income, and each shareholder has to report this information on their own tax return.
One big rule for S-Corps is that anyone who works in the business and is also an owner must receive a reasonable salary. This salary is subject to payroll taxes like Social Security and Medicare.
After paying yourself a salary, you can take the rest of the company profits as a distribution, which is not subject to these taxes. This is a key benefit of the S-Corp structure.
It is important to pay yourself a reasonable salary because the IRS pays close attention to this rule.
If you pay yourself too little, the IRS may decide that some of your distributions are actually salary, and you could face back taxes and penalties. So make sure that your salary is similar to what others earn for doing the same kind of work.
One of the biggest benefits of having an S-Corporation is that you can save money on self-employment taxes. Here’s how it works and some tips to make the most of it.
If you are a Sole Proprietor, Partnership, or LLC owner, you have to pay self-employment tax on all your earnings. Making the change to be taxed as an S-Corp, you only pay the “self-employment tax” on that W-2 salary you take. This means you can significantly reduce how much of your income is taxed this way.
This is how that works:
If you own an S-Corp and work in the business, you are required to pay yourself a salary. This salary is treated just like any other employee's salary, which means it is subject to payroll taxes like Social Security and Medicare (a total of 15.3%).
This salary must be “reasonable,” meaning it should be similar to what others in your field are paid for the same work. If you set your salary too low, the IRS might decide to reclassify some of your extra income as salary and charge you more in taxes.
Once you have paid yourself a reasonable salary, any extra profits can be taken as distributions.
This is where the magic happens with the tax savins because these distributions are not subject to self-employment tax, which means you save money. By balancing your salary and distributions, you can reduce your overall tax liability.
The goal is to set your salary high enough to meet IRS rules but low enough to maximize the amount you take as distributions. This strategy can save you thousands of dollars each year.
Finding the right balance between salary and distributions is key to maximizing your savings while staying within the rules. You can use industry data and job statistics to help decide on a reasonable salary.
Imagine your S-Corporation makes $120,000 in profit for the year. Instead of paying self-employment tax on all of that, you decide to take a salary of $60,000, which is subject to payroll taxes, and then take $60,000 as distributions.
If you didn't have the S-Corp structure, you would have paid $18,360 in self-employment taxes on the full $120,000. By using an S-Corp, you save a lot of money in taxes.
Now, think about reinvesting that $9,180 back into your business. You could hire new employees, buy better equipment, or increase your advertising budget, all of which could lead to more growth. Or you could use those savings to invest in your personal future, such as by putting the money into a retirement account.
There is a lot of misinformation about what a “reasonable salary” is and how to determine that.
While this is not the topic of this article, we do have resources around what is “reasonable compensation” for the business owner than you can find in our resource center at MakeTaxesFair.com . We specifically have a resource for how to address this under the Reasonable Compensation training and playbook.
The bottom line is that you should NOT set your salary without examining that resource otherwise you could be putting your S-Corporation at risk or over paying thousands of dollars in payroll taxes.
To keep your S-Corp in good standing with the IRS, it's important to file all your tax documents on time. Here are the main filing deadlines you need to know:
To be eligible for S-Corp tax benefits, your business must meet some important rules set by the IRS.
Here are the main requirements:
We never recommend that anyone do the legal or tax administration for their business on a DIY basis. The starting point for any corporation formation should be with a knowledgeable attorney who can guide you through the maze of legal complexities and avoid missteps that could have easily been avoided.
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To become an S-Corp, you must file Form 2553 with the IRS. All the shareholders have to agree to this change. You need to file the form within two months and 15 days after the start of the tax year. Filing on time is really important—if you miss the deadline, you might not be able to get the tax benefits until the next year.
If you already have an LLC or a C-Corporation, you can choose to be taxed as an S-Corp when your profits are high enough that the tax savings will be worth the extra paperwork and requirements.
To keep your S-Corp status, you must follow certain corporate rules, called formalities. These formalities include:
If you do not follow these formalities, you could lose your S-Corp status or risk being personally responsible for the business’s debts.
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S-Corporations can be a great way to save on taxes, but they also come with some rules and challenges. Here are the pros and cons:
An S-Corporation is a good choice if your business is making a lot of profit and you want to save on self-employment taxes. Here are some situations when choosing an S-Corp might be a good idea:
While an S-Corporation is a great tax savings vehicle, there are circumstances where becoming an S-Corporation would NOT be ideal. Some examples of when a business should avoid the S-Corporation election or formation are:
S-Corporations are a powerful tool for small business owners who want to lower their tax bills while still enjoying the benefits of a corporation. By paying yourself a reasonable salary and taking extra profits as distributions, you can save money on self-employment taxes and keep more of what you earn.
If your business is earning steady profits and want to save on taxes, an S-Corp could be an ideal solution. Be sure to meet all IRS requirements, keep accurate records, and pay yourself a reasonable salary to stay compliant with the law. Partnering with a tax professional can help you make the most of the S-Corp structure and steer clear of potential pitfalls.
In the next article, we will discuss C-Corporations—a business structure often associated with large companies but one that may also offer unique benefits for smaller businesses, depending on your goals. If you have questions or need help, make sure to reach out and start a conversation.