By electing to have your business taxed as a subchapter S Corporation—commonly called an S Corp—you could save up to 15.3% on your tax bill. The election is available whether your business is a traditional subchapter C Corporation, or a limited liability company.
The tax savings from the election come from how each dollar of business income is taxed. Under subchapter C taxation, a corporation pays tax on its own income. Out of what’s left, it makes distributions to its owners, who pay their own tax on receipt of the distribution. This is called double taxation.
By contrast, in an LLC or a partnership, income is not taxed at the business level. It is passed through directly to the business owners. The owners report all company income on their personal returns. This avoids the cost of double taxation. The drawback is that all of the ordinary income passed through to the business owners is subject to self-employment tax, which is currently 15.3%.
An S Corporation is a pass-through entity like an LLC or partnership. All S Corporation income is reported on the owners’ personal tax returns. The business itself pays no tax. Double taxation is avoided. This makes the S Corp a better tax option than a C Corp for most businesses.
But unlike an LLC or partnership, distributions from an S Corporation to its owners are not subject to self-employment tax. That results in a 15.3% savings on all distributions from the S Corporation to the S Corporation owners. Not bad for filing a simple form with the IRS.
But there is a catch. Limited liability companies and partnerships are owned and operated by their members or partners. Corporations on the other hand, both C and S Corps, are distinct legal entities from their owners–the shareholders–and each must be operated by at least one employee. That means that C Corps and S Corps have to run payroll.
Payroll imposes some administrative expense, which eats into the tax savings. But more importantly, payroll is subject to payroll tax, which consists of Social Security tax of 6.2% and Medicare tax of 1.45% for both the employer and employee. That adds up to 15.3%.
In most small businesses—and subchapter S was designed to benefit small businesses—the owners are the employees. So the owners dodge the 15.3% self-employment tax, only to get slapped with the combined 15.3% payroll tax.
But all is not lost. The IRS permits S Corporation shareholders to wear two hats: employee and owner. Wearing the employee hat, a shareholder receives payroll and pays his or her half of the payroll tax. The company pays the other half. That 15.3% cannot be avoided.
But shareholders also wear an owner hat. And recall that in an S Corporation, distributions to owners are not subject to self-employment or payroll tax. So whatever the S Corp distributes out to its owners—as opposed to pays them through payroll—is not subject to the extra 15.3% tax.
This leads to another catch. At this point you’re probably tempted to run payroll with your salary set to about a dollar a year. But the IRS knows that game. There is a requirement, applicable to S Corporations, that you pay yourself—if you are both owner and employee—a reasonable salary.
No one is quite sure what a reasonable salary is. The IRS does not issue guidance on the question. But they will audit and penalize an inadequate salary. So tread lightly. This is where you should talk with your accountant about standards in your industry.
A commonly rule of thumb—which may not apply in all cases—is that you should run at least half of what you take out of the business through payroll. In that case, you’re still saving around 7.65% in taxes. So if you’re taking home $50,000 a year, the S Corp election will save you from $3,825 in taxes. Not bad for filing a simple form with the IRS.