Overview
Structuring your business as an S corporation enables income above a business owner’s reasonable compensation to be exempt from self-employment tax. Common terms include S corp, S subchapter, pass-through entity, and flow-through entity.
Do I Qualify for an S Corporation?
S corporations are not taxed at the corporation level; instead, they pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes, acting as a pass-through entity.
2023 S Corporation Details
S corporations function as pass-through entities, wherein they don't undergo taxation at the corporation level. Instead, they pass corporate income, losses, deductions, and credits to their shareholders for taxation purposes. Shareholders of S corporations report this income and loss on their individual tax returns and are taxed at their personal income tax rates, thus allowing the S corporation to bypass double taxation on corporate income.
A significant advantage of the S corporation model is that not all earnings are liable for self-employment tax. Those holding shares in an S corporation are seen as owner-employees. This implies that the net profit derived from the business is a mix of self-employment income and a return of capital stemming from the shareholder’s investment in the business.
The portion considered as self-employment income is disbursed as wages and is susceptible to self-employment tax, while the return from investment is distributed and isn't subject to this tax.
To prevent business earnings from being entirely treated as distributions exempt from self-employment tax, S corporation shareholders must receive "reasonable compensation." Amounts perceived as reasonable compensation are considered as wages. Both the shareholder and the corporation are responsible for FICA and Medicare taxes on these wages.
Given that only a segment of the net profit is subject to self-employment taxes, business proprietors can accrue substantial savings on these taxes. These savings are accessible as long as the S corporation remains operational. Nonetheless, all net profit, regardless of being a distribution or wage (reasonable compensation), remains taxable.
Benefits
Enhanced liability protection for the company.
Diminished taxable income.
Reduction in self-employment tax.
Considerations
Continual payroll is mandatory.
A detailed compensation analysis is advised for supporting the calculation.
Business proprietors must file an additional 1120S tax return.
Assumptions When Opting for the S Corporation
The business proprietor qualifies to be a shareholder in an S corporation.
The business proprietor has chosen to incorporate or establish an LLC that might be taxed as an S corporation.
The business proprietor has submitted Form 2553 (Election by a Small Business Corporation) to the IRS.
Requirements for S Corporation Eligibility
For a business to qualify for S corporation status, it must:
Be domestically based.
Possess only eligible shareholders, including individual persons, estates, and specific trusts.
Not have over 100 shareholders.
Issue only a single class of stock (though stock can be divided into voting and non-voting shares).
Not operate as an ineligible business, such as certain financial institutions, insurance firms, or domestic international sales corporations.
Partnerships, other corporations, and non-resident foreigners cannot hold shares in an S corporation.
Business Entities Eligible for the S Corporation
Schedule C
S Corporation
C Corporation
Partnership
Comments