What is an S Corporation and How Can it Benefit Me?
This page is part of our Guide to the Law for Entrepreneurs and Business Owners.
An “S Corporation” aka “S Corp” is a type of tax treatment for a business (even a business with one owner) that usually can save the business owner(s) lots of money. Often, it allows you to save thousands of dollars per year, depending on business earnings.
For example, if you make $60,000 net income, you could save up to $3,000. If you make $100,000 net income, you could save up to $8,000. Serious Savings Alert!
But taxes can vary significantly depending on lots of factors, so an S corp may not be appropriate for everyone. Whether an S corp is right for you is usually a question for an accountant/CPA. The actual set up of the S corp is exclusively the job of an attorney (although some accountants do the actual set up for their clients, which is generally considered an unlawful practice of law).
What exactly is an S corporation?
First let’s differentiate between legal structures and tax structures.
A legal structure is the form the business operates under, whether a formal entity – corporation, LLC (limited liability company), etc, or a “non entity” – sole proprietorship, or general partnership.
A tax structure (or tax treatment) is how the business is taxed. Here are some default tax structures:
Sole proprietorship, partnership, LLC: profits and losses “pass through” to owners, and owners pay the tax as individuals. Profits are subject to self-employment tax.
S Corporation: “pass through” taxes, as above, but “distributions” of profit to owners, above normal salary, are NOT subject to self-employment tax.
C Corporation: profits and losses are taxed first at corporate level, then when passed to owners, taxed again at individual level. (This is known as “double taxation”)
But keep in mind that the tax structure does NOT need to match the legal structure. So, an LLC can be “taxed as” an S corporation.
An S Corporation is simply a tax structure that is applied to an entity or legal structure. Despite the name, the legal structure is not necessarily a corporation at all, but could instead be an LLC (limited liability company). Once a business has formed either a corporation or LLC, it can then choose (elect) to “become” an S Corp by filing paperwork with the IRS (Form 2553).
It doesn’t really become a different type of entity at that point; it’s simply a change to the tax structure.
So an S corp can be either:
- A corporation, taxed as an S corporation
- An LLC taxed as an S corporation.
In either case, people often simply call it an “S corporation.”
How can an S corporation save me money?
With an S corporation, you can end up paying less taxes than with a sole proprietorship, partnership, “regular” LLC, or C corporation (“regular” corporation). This is because all of these other tax treatments consider earnings to be self-employment compensation, and thus require you to pay self-employment tax on the full amount you earn.
But with an S corporation, you can pay out a portion of your earnings as distributions rather than self-employment compensation. There is no self-employment tax on distributions.
While you may want to pay out all earnings as distributions, it doesn’t work that way. The IRS requires you to pay yourself a “reasonable” salary so that they can collect some self-employment tax from you. The definition of reasonable is highly variable, depending on the type of work you do. Discuss this with a CPA.
What other benefits can I get from an S corporation?
If you are currently operating as a “sole proprietorship” or “general partnership,” you would gain additional benefits from creating an S corp. In particular, you would get “liability protection” aka “limited liability.” See more about limited liability.
Are there any drawbacks to having an S corporation?
Because you need to pay yourself a salary, you will need to set up a payroll system. This adds a bit of cost and complexity. But if you use a service like Gusto, it’s very manageable and not too costly.1NOTE: Law Soup Media may receive compensation from this vendor if you use any of their services. Thank you for your support!
And if you don’t already have an appropriate entity, you will need to create one, which can mean initial and ongoing costs.
So how do I create an S corporation?
Once a business has formed either a corporation or LLC, it can then choose (elect) to “become” an S Corp by filing paperwork with the IRS (Form 2553).
Talk to a lawyer and an accountant for more. See options for getting legal help.
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