More than 65 years ago, the United States Congress established S corporations to eliminate double taxation and encourage the creation of small businesses. Today, there are more than five million S corporations in the U.S. — three times the number of C corporations.
How are S corporations different from other types of businesses? They are considered pass-through entities, meaning they do not pay corporate taxes but instead pass tax liabilities to their individual shareholders. S corporation owners are not personally liable for actions of the company, and their personal assets are protected from creditors seeking to collect from the business.
Unlike S corporations, C corporations require both the business and owners to pay income taxes. However, an S corporation failing to file IRS Form 2553 on time may result in them being taxed as a C corporation.
There are strict criteria businesses must meet to qualify as an S corporation. As a limited liability company (LLC) or corporation that has elected to not be treated as a taxable entity, entities must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts and estates
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies and domestic international sales corporations)
Practical Tax Perks
Again, a key reason Congress established S corporations was to get rid of double taxation. Such businesses do not have to pay both corporate and personal taxes on the same income, putting them in that category exempt from two-tiered taxation.
Any S corporation earnings are allocated to shareholders according to their ownership percentage. Shareholders report these earnings on their individual income tax returns.
The pass-through structure of S corporations sometimes produces lower overall tax liabilities for shareholders. This is because the shareholders of the corporation can draw a salary and other distributions as an employee.
Self-Employment Taxes
S corporations not only are not required to pay federal income tax, but they also are not taxed on self-employment income, which includes Social Security and Medicare. This is another way such businesses reduce their tax liability by up to 14.3 percent per each dollar of profit.
Owners of S corporations maybe subject to self-employment taxes, especially if they provide services to the business. To avoid this, they should pay themselves a “reasonable salary” as employees and therefore receive a W-2.
What is Considered a Reasonable Salary?
The IRS does not detail exactly what constitutes a reasonable salary; it only describes it as proper compensation for the services provided to the corporation. To calculate this amount, an S corporation owner should use the “average” salary for their position. This salary must be considered “reasonable” for the industry of the S corporation and the role the owner takes.
Because S corporation owners are paid as employees, their wages are subject to the Federal Insurance Contributions Act (FICA), and they must pay payroll taxes on their salary. By issuing a lower W-2 wage, these owners can decrease their self-employment tax without impacting the corporation’s overall profit.
Along with the “reasonable salary,” any remaining business profits can be distributed to the owners as they choose and are not subject to self-employment taxes.
How are S Corporation Taxes Calculated?
The amount of taxes an S corporation owes varies widely based on size, revenue and expenses. Here’s one example:
S Corporation SCLLC had a 2023 revenue/gross profit of $150,000. The owner’s salary was $97,500, resulting in a business taxable income of $52,500. Self-employment tax, which is a 15.3 percent tax on the first $160,200 of income, would be $14,918. The result is a tax savings of $8,033.
What More Should I Know About S Corporations?
Keeping track of tax regulations for S corporation typically requires the assistance of an experienced tax professional. Here, though, are a few things owners of S corporations should keep in mind:
- An S corporation is considered a separate tax entity and usually must file its own return.
- S corporations are required to file Form 1120-S to report their income and losses.
- Shareholders should report their S corporation income on Schedule E of their individual tax returns.
- A shareholder’s individual income tax rate ranges from 10-37 percent in 2024.
- The annual federal tax return for S corporations is due on March 15.
- A business does not need to set up an S corporation to have employees and payroll.
- Misallocating income and deductions among shareholders can lead to IRS penalties.
- It is important that S corporations keep accurate records of their business income and expenses.
- Depending on the nature of the business, S corporations may be subject to additional taxes, including state and local taxes, sales taxes and excise taxes.
StenTam Tax Services: Experience + Technology + Compliance = Confidence
We get it — taxes typically are extremely complicated, especially for most business owners. That is why the StenTam Tax Services team draws on sophisticated technologies and a diverse background in tax services to help S corporations and other types of businesses accurately and expediently navigate the process. Along with management of complex tax returns and vast knowledge of tax credits, we offer coordination of business and personal tax planning, proactive tax consulting and more. Contact us today, and a member of our team will be in touch soon.
