What is an S Corp?
An S Corporation is when special tax rules apply to a corporate entity. The name “S Corporation” is a bit of a misnomer because it actually refers to how a business handles paying its taxes. This is not how we normally think of a “corporation” i.e. the legal entity.
A subchapter S is a tax classification, used by corporations, to pass income and losses through to its members in the form of employee salaries or dividends.
S Corporations elect for special tax rules where profits and/or losses pass through to the owners. In an S Corp, the owners (called members) can be compensated either through employee salaries or dividends (called distributions). Regular LLC’s members are only compensated by what are called draws.
The salaries of an S Corporation member are hit by the same costly taxes as the default LLC’s draws. Unlike the default LLC, S Corporations have the ability to give members distributions which have much better tax treatment! While a standard issue LLC is paying expensive Social Security and Medicare taxes on all it’s draws, those that elect for S Corp tax rules are able to avoid them considerably.
Difference Between LLC and S Corp
|Name||Legal Entity||Tax Classification|
Here you can see that an LLC is just a state level legal entity, not a tax classification the IRS will consider. In fact the IRS defaults your LLC’s tax classification to “disregarded” basically treating you as if you were the business. An S Corporation is an optional tax classification your LLC can elect.
How S Corps Create Tax Savings
Now that we’ve covered how S Corps help you to avoid Social Security and Medicare taxes on some (not all) of your compensation, let’s talk about how exactly they do that. As part of starting an S Corp you’ll need to become a regular W-2 employee paying yourself a “reasonable salary”. While your W-2 salary will still be taxed at a similarly high rate, similar to your regular LLC income, some of your profits can now become “distributions”.
The above is intended for member managers, or owners that are actively involved in the business. If you qualify as a passive investor of an S Corp then you are allowed to be compensated solely through distributions.
S Corp distributions are paid in a way that resembles how normal corporate shareholders receive tax advantaged dividends. Distributions are the key mechanism that creates your S Corporations tax savings, because they do not have to pay into Social Security or Medicare! This does not necessarily mean that your distributions are tax free, just that they have a huge tax advantage over earned, salary, income.
Disadvantages of an S Corp
In order to become an S Corp and maintain its status you’ll need to jump through some extra hoops that are new to most LLC owners:
Replace your regular LLC “draws” (how you’ve been normally paying yourself) with an employee salary. This means you’ll need to become a W-2 employee of your business.
Ensure all your members qualify for the S Corp’s restrictions on ownership. Important requirements include: being a US resident, having only a single class of stock, limiting ownership to 100 members, and more.
New IRS scrutiny around each member’s “reasonable salary”. So if you’re involved in the day to day operations and get paid in distributions, you’ll be expected to receive a reasonable salary. Failure to do this can lead to an IRA audit and worse.
Filing fees necessary to create your S Corporation should also be considered and vary by state.
Your salary will be subject to new taxes like FICA, State Unemployment, and sometimes State Disability. In order to pay all these taxes businesses often use a payroll system that withholds all taxes both for your state and at the federal level.
Plenty of additional paperwork and maintenance with both state-level agencies and the IRS should be expected.
This list is not to be considered comprehensive because requirements can vary by state as well as the unique situation of your business. Consulting with a qualified CPA familiar with the requirements in your state is critical to understanding all of the trade offs that apply to you.
Should Your Business Become an S Corp?
The biggest question you’ll need to answer is: are the tax savings big enough in your state to make the S Corp worthwhile? S Corps can be a tremendously rewarding tax strategy for the right business. However it’s important to understand that the advantages must outweigh the unavoidable disadvantages (ie new taxes and paperwork).
Every state has different rules and trade offs for S Corporations, which is why we’ve provided a unique calculator for each one. If the calculator for your state does not find enough savings yet, that’s very common for new businesses. However It’s important to keep coming back to check your results as your business income grows. So be sure to bookmark the calculator for your state for up to date results!
Forming an S Corp
These steps assume you are an LLC owner already, so if you’re not incorporated, make sure to protect yourself with a good legal entity first! If you’ve formed an LLC for your business you’re ready for the next steps:
Make sure you meet the main S Corp requirements: All members are US Residents, you have only 1 class of stock, only 100 members, and etc.
File form 2553, which is time sensitive in terms of how it must be filled out, to inform the IRS you wish to be taxed as an S corporation.
You’ll need to register with all necessary state agencies using the forms they specify, which varies from state to state.
As previously mentioned, you’ll need to start running payroll for all salaries at minimum for each quarter of your fiscal year.
Requirements of starting an S Corp vary by state, industry, and the existing corporate membership. Please know how these factors might affect your filings.
Starting an S Corp is complicated and time consuming, so finding a qualified small business CPA is the best choice for the vast majority of business owners. Unless you're well versed in this process already, seeking professional guidance is the smart move.
Does my business name change? (from LLC to S Corp)
No. If you’re an LLC now you’ll be an LLC after you qualify as an S Corporation. This is because your LLC is a business entity, while an S Corp is a tax classification.
Do I have to pay myself a salary?
Yes. Once S Corp owners learn about the tax advantages of their distributions, paying themselves a salary becomes much less exciting. However not paying yourself a “reasonable salary” will quickly earn you unwanted IRS scrutiny and eventually an audit. What qualifies as reasonable varies so be sure you consult with a CPA about setting your salary. You may not have to pay yourself a salary if you qualify as a “Passive Member” of your S Corp.
How many new taxes will I be exposed to?
It depends on the state. If your S Corp is in California you’re exposed to 3 new taxes. If your S Corp is located in Florida you’re exposed to 2. At minimum your business will be exposed to 2 new taxes, however it can be many more (such as S Corporations located in New York City).
How many more forms will I have to fill out?
It depends on the state. Often it’s a function of how many more kinds of taxes you’ll need to pay, because you’ll need to register with the relevant agency in order to pay them. Please account for the ongoing maintenance and filing fees you’ll be responsible for as well. Your CPA should help you with all of this.
How much more work is filing taxes?
It depends. S Corporations will absolutely result in more paperwork at tax time, however the exact amount depends on your situation. At minimum you’ll need to file a Form 1120S, Schedule K-1, 941, 940, W-3, and W-2 each year. These forms are straightforward for any CPA’s well versed in S Corps.
Ready to Get Started
Select the state your business is in from the list above. From there answer the brief questions about your situation and your results will be automatically created. Once you're confident an S Corp could be the right move for your business, request help from our CPA network.
Discussing your situation with a qualified CPA, specializing in small business taxes for your state, is the next step. A good CPA will understand in full detail if an S Corp can help your unique tax strategy. There’s always a CPA’s with small business experience in your state ready to discuss your next step.