What Is An S Corporation?
An S corporation is a type of pass through entity structure, that may have between 1 and 100 shareholders. Income and expenses pass through the S Corporation to the shareholders, without being taxed. The taxes for any net profits received by the shareholders, are paid by the shareholders.
This allows S corporations to avoid the double tax paid by C corporations, who are taxed once at the corporate level, and taxed again at the individual level.
What is the Benefit of An S Corporation?
S Corporations allow business owners to reduce their self-employment tax, by splitting the profits they receive into two types of income; wages (taxed unfavorably) and distributions (taxed favorably).
How Wages Are Taxed
Wages are considered earned income, meaning, you worked to earn the income. Wages are taxed less favorably because they incur ordinary income tax, and the dreaded 15.3% self-employment tax.
How Distributions Are Taxed
Distributions are considered passive or unearned income, meaning, income was received, but there was no work. Shareholders still pay ordinary income tax on distributions, but the big benefit is that there is no 15.3% self-employment tax.
How S Corporation Owners Pay Themselves
Owners are unique in the sense that they are an employee of their business, and they are a shareholder who owns the company.
First, as an employee, owners pay themselves a reasonable wage. The topic of what constitutes a reasonable wage for an owner is an in-depth discussion. For the purpose of this article, we'll define a reasonable wage as the amount you could pay someone else to perform the work you are doing.
Example -- An owner of a construction company could reasonably pay themselves $70K/year as a general laborer because if they had to hire a skilled laborer, they could find one for that wage (or similar). However, if they tried to pay themselves $30K/year, it would be an unreasonable compensation where the owner has paid themself too little in order to avoid self-employment taxes, because no skilled laborer would work for that wage.
Second, after all the expenses are paid including the owner's wage, the remaining profits are paid to the shareholders as a distribution. Generally, the owner is the sole shareholder who receives all the distribution. The distributions are subject to ordinary income tax, but are not subject to the 15.3% self-employment tax.
Example
Cathy has a design company, which is taxed as an S corporation. Her business brings in revenue of $200K/year. Her business expenses, including her 1 assistant, is $80K/year. After expenses, Cathy's business profits $120K.
Wage -- Cathy pays herself $70K/yr., which she will owe ordinary income tax + 15.3% self-employment tax.
Distribution -- The remaining profits of $50K/yr., she pays to herself as the sole-shareholder, which she will owe ordinary income tax but not self-employment.
In this example, Cathy has saved herself $7,650 in taxes.
How To Become An S Corporation
There are (2) ways to become an S corporation. The direct method is to create a new entity with the IRS, and select to be an S corporation. The other method is take your existing LLC and elect for it to be taxed as an S Corporation.
If you know from the beginning that your business will make substantial net income after expenses, go ahead and start your S corporation. If you are unsure, start with an LLC and you can always convert to an S corporation when you are ready.
What Else Do I Need To Know?
S corporations have their own corporate tax return, whereas LLCs and sole-proprietorships are taxed on your personal return. This means, S corporations require more work and costs in tax preparation.
Businesses that are partnerships, or passive (such as rental real estate), should not be an S corporation.
Final Thoughts
There are many rules, forms and deadlines that are unique to every person's situation. We recommend getting in contact with an experienced professional who can help walk you through your situation.
If you need help with your situation, contact us at (425) 298-5453, or info@ontrackadmin.com.
About The Author
Gabriel M. Diaz is the owner of On Track Admin, a company who specializes in admin support, tax support, and bookkeeping for service-based small business owners in Sammamish, Seattle, Bellevue and King County, WA.
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