What Is an S Corporation? Benefits, Drawbacks, How to Form - NerdWallet (2023)

FAQs

What are the benefits of an S corp? ›

Once a valid S corporation election is terminated or revoked, the corporation or any successor corporation is generally prohibited from making a new election for five years. The five-year period begins with the tax year after the first tax year for which a termination or revocation is effective (IRC § 1362(g) ).

Tax Liability and Reporting Requirements

Non-S corp. LLC owners must pay a 15.3% self-employment tax on all net profits*. S corporations have looser tax and filing requirements than C corporations. An S corp. is not subject to corporate income tax and all profits pass through the company.

Tax advantages

The main benefit of incorporating as an S corporation over being self-employed is the tax savings on self-employment taxes (Social Security and Medicare). For each dollar of profit, it could mean as much as 14.13% in savings when it's time to pay taxes.

Advantages of a corporation include personal liability protection, business security and continuity, and easier access to capital. Disadvantages of a corporation include it being time-consuming and subject to double taxation, as well as having rigid formalities and protocols to follow.

Because of pass-through taxation, the S corporation doesn't pay federal income tax on its business income the way a C corporation does. Instead, business income, deductions, losses, and other tax items flow through (or pass through) to the business owners (e.g., the shareholders).

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.

If you opt to have your business taxed as an S corp, then you're considered an employee, and you must pay yourself a salary if you are active in your business. You can draw money from the business on top of your owner's salary, but this is referred to as a shareholder distribution in an S corporation.

One of the tax benefits of operating an S corp over an LLC is the savings on self-employment taxes. Members of an LLC must pay a 15.5 percent self-employment tax, whereas S corp shareholders only pay Social Security and Medicare taxes on the salary that they receive from the corporation.

What is the best way to pay yourself as an S corp? ›

S corp owners who classify as employees can't take a car tax write-off as a sole proprietor can. Instead, write a reimbursement check from your S corp to your individual bank account for the business use of your personal car.

S corporation write offs are costs that you have incurred while operating your business that can be removed from your income, thus reducing the amount of tax you'll be paying.

The right time to convert your LLC to S-Corp

From a tax perspective, it makes sense to convert an LLC into an S-Corp, when the self-employment tax exceeds the tax burden faced by the S-Corp. In general, with around $40,000 net income you should consider converting to S-Corp.

(A 2-percent shareholder is someone who owns more than 2 percent of the outstanding stock of the corporation or stock possessing more than 2 percent of the total combined voting power of all stock of the corporation.)

At the end of each year, all S corporation profits are allocated to the corporation's shareholders. Even if you and your fellow shareholders choose to leave some or all of the profits in the corporation, taking nothing as distributions or salaries, you will still be required to pay tax on those profits.

In general, you'll want to consider converting from an LLC, partnership or sole proprietorship to an S-corp when your profits are greater than the amount that you'd reasonably expect to pay in owner salaries.

You may find yourself in a position where converting your S Corp to an LLC is highly beneficial. The main reasons most S Corps convert to LLC are to avoid capital gains tax, to get different management options, to allocate profit share differently, and to have more flexibility in how they're taxed.

Advantages of Converting from an S Corporation to LLC

There are several advantages to converting to an LLC: After conversion, the corporate rules that S corporations observe are eliminated. An LLC doesn't have to keep a board of directors, nor does it have to record minutes, because the company can be member-managed.

When comparing an S corp vs 1099, the two do not have to be mutually exclusive. The IRS requires companies to use 1099s on all employees working as independent contractors, but S corps come with certain restrictions and benefits. S corps are allowed to reduce self-employed taxes that are paid.

Is it better to be an S corp or C Corp? ›

Single layer of taxation: The main advantage of the S corp over the C corp is that an S corp does not pay a corporate-level income tax. So any distribution of income to the shareholders is only taxed at the individual level.

Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise capital funds.

Forming a corporation allows you to: Secure your assets. One of the main advantages* that corporations have is that the owners enjoy limited liability protection and are typically not personally responsible for business debts. This means that creditors can't pursue your home or car to pay business debts.

If you're running short on cash or have an unexpected expense on the homefront, you can borrow money from your S Corporation. However, you can't simply just scribble out an IOU or do a quick transfer of money between accounts. You will need to obtain an official promissory note that is properly prepared and executed.

Avoiding Double Taxation

The S Corp and LLC are two of the most common and favorable business structures for small businesses, since both avoid double taxation. LLCs and S Corps are taxed more like a sole proprietorship or partnership as opposed to a C Corp, which is taxed as a separate entity from its owners.

You are probably familiar with paying 15.3% for Social Security, Medicare, and self-employment taxes on your entire profits. S-Corp election lets you split your profits into “shareholder wages” (subject to 15.3% self-employment taxes) and “distributive share” (NOT subject to 15.3% self-employment taxes).

You must file California S Corporation Franchise or Income Tax Return (Form 100S) if the corporation is: Incorporated in California. Doing business in California. Registered to do business in California with the Secretary of State (SOS)

An S corp can be owned by any U.S. citizen or U.S. resident. The law requires all owners to be individuals and caps the maximum number of owners at 100. Trusts, LLCs, partnerships, C corporations, and S corporations cannot own an S corp.

Does having an S Corp prevent me from paying self employment tax? ›

The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes. Those profits are only subject to income tax.

Throughout the tax year, you must maintain a detailed balance sheet for your S corporation. When it comes time to file taxes, you'll be able to refer to this sheet in order to remain organized.

What is the 60/40 rule? The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.

I've heard it range from $45,000 to $70,000 in taxable income (your business's, not your own). Personally, I think if your business is making more than $60,000 in profit every year, then you should look into forming an S corp. Keep in mind that we're talking about taxable income, not gross revenue.

Here's the bottom line: If you drive a lot for work, it's a good idea to keep a mileage log. Otherwise, the actual expenses deduction will save you the most.

The 6,000-pound vehicle tax deduction is a rule under the federal tax code that allows people to deduct up to $25,000 of a vehicle's purchasing price on their tax return. The vehicle purchased must weigh over 6,000 pounds, according to the gross vehicle weight rating (GVWR), but no more than 14,000 pounds.

They can reimburse any amount, from below the IRS standard rate, or above the IRS standard rate. They can reimburse for gas and insurance but not oil changes, or anything else that it wants to pay for (that is vehicle related).

Advantages of a corporation include personal liability protection, business security and continuity, and easier access to capital. Disadvantages of a corporation include it being time-consuming and subject to double taxation, as well as having rigid formalities and protocols to follow.

What is the advantage of an S Corp over a C Corp? ›

Single layer of taxation: The main advantage of the S corp over the C corp is that an S corp does not pay a corporate-level income tax. So any distribution of income to the shareholders is only taxed at the individual level.

If you are an S corporation then you may be liable for... Employment taxes: Social security and Medicare taxes and income tax withholding. Federal unemployment (FUTA) tax.

The S corp income tax rate refers to the federal, state, and local individual income taxes that S corporations are required to pay. Owners of S corporations need to pay 0 to 13.3 percent state and local income taxes and a top marginal rate of 39.6 percent for federal personal income taxes.

The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, unlimited life, and so forth. 4.

Forming a corporation allows you to: Secure your assets. One of the main advantages* that corporations have is that the owners enjoy limited liability protection and are typically not personally responsible for business debts. This means that creditors can't pursue your home or car to pay business debts.

The primary difference between an S corp and a C corp is the manner in which they are taxed by the IRS. A C corp has its profits and losses stay in the business and files its own tax returns. A C corp also pays a 21% flat tax on profit.

The biggest difference between S corporations and LLCs is how they are taxed. S corporations are taxed as pass-through entities, meaning that the profits and losses are passed through to the shareholders' personal tax returns, while LLCs can choose to be taxed as either a pass-through entity or a corporation.

Because of pass-through taxation, the S corporation doesn't pay federal income tax on its business income the way a C corporation does. Instead, business income, deductions, losses, and other tax items flow through (or pass through) to the business owners (e.g., the shareholders).

The annual tax for S corporations is the greater of 1.5% of the corporation's net income or $800. Note: As of January 1, 2000, newly incorporated or qualified corporations are exempt from the annual minimum franchise tax for their first year of business. (See below.)

S-Corp election lets you split your profits into “shareholder wages” (subject to 15.3% self-employment taxes) and “distributive share” (NOT subject to 15.3% self-employment taxes). Active owners in an S-Corp must pay themselves a reasonable salary, but realize a 15.3% savings on the rest of their retained profits.

What is the annual fee for an S corp? ›

S corporations are subject to the annual $800 minimum franchise tax.

Setting Up Payments in an S Corp

Generally, owners of an S corp qualify as employees of the business and must receive a salary. If you're an owner who's actively involved in managing your S corp, you're considered an employee of the company and you'll pay yourself a W-2 salary.

It's up to you to determine how often to pay yourself an employee salary. It might be once or twice a month, once a week, every other week or less often. If you ever need more money, you can take a shareholder distribution at any time.