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Understanding S-Corp Taxation: What It Is and When to Use It

By March 13, 2019April 5th, 2021Business Formation
understanding S Copr taxation

To protect their personal assets from liability, individuals and small business owners often opt to form corporations or limited liability corporations (LLCs). But they may not realize that they could also be doing more to protect their earnings: By choosing to file as an S Corporation (S-Corp), they can further reduce their taxes while still enjoying the other benefits of a corporation or an LLC.

LLC vs. S-Corp

While a quick Google search will yield plenty of articles outlining the differences between LLCs and corporations, it’s really comparing apples and oranges. LLC or corporation is a business entity choice—a kind of business that you own. Choosing to be taxed as an S-Corp refers to a classification you submit to the Internal Revenue Service at the time the entity is formed or thereafter (with some restrictions).

Unless otherwise specified, LLCs will be automatically taxed as sole proprietors (single-member) or partnerships (multi-member). In either case, they are subject to Medicare and social security taxes, collectively known as self-employment taxes.

How S-Corp Taxation Works

All of an LLC’s earnings are typically taxed as income. So, if an LLC made $300k in a year, then all $300k is subject to self-employment taxes. Ouch. If a corporation does not make an S-Corp election, it will be subject to double taxation (taxed on its profits and its shareholders will be taxed when they receive dividends). Also ouch.

If that same LLC elects to be taxed as an S-Corp, then the owner (member) designates a reasonable salary to pay themselves, and only this salary would be subject to Medicare and social security taxes and any profit “flows through” the LLC and is typically taxed at a preferable rate. And if that same corporation elects to be taxed as an S-Corp, it pays no tax at the corporate level and any profit “flows through” the corporation and is typically taxed at a more preferable rate. Now that sounds better!

Qualifying for S-Corp Taxation

Not every LLC and corporation are eligible to be taxed as an S-Corp. Certain key qualifications must be met first, and even then, it may not make financial sense for that business.

Most single member LLCs and single shareholder corporations qualify for S-Corp taxation unless an owner is a nonresident foreign national or the owner is an “institutional shareholder” like another LLC or corporation. The entity can only have one class of equity and it number of qualifying owners must be less than 100.

If an entity fails to on just one of the S-Corp restrictions, it can cause the entity to lose its preferential status with significant tax consequences.

Does S-Corp Taxation Make Sense for You?

Electing to be taxed as an S-Corp might make perfect sense for your business. After a conversation with my firm and their tax advisor, our client, Outsource Marketing, made the change a few years ago.

“After Mark reviewed our situation with our accountant, it was clear it was the right move for us,” said Patrick Byers, owner of Outsource. “Bracepoint made the change painless for us.”

Not every business is a perfect candidate to become an S-Corp. For example, if a business doesn’t have enough revenue, they may find it necessary to assign themselves an unrealistically small salary for taxation to make it work. The salary must be reasonable for the work they do with substantial business earnings leftover. So, freelancers or similar small business owners with lower earnings may find that S-Corp taxation isn’t right for them.

If you’d like to consider making this change, contact us. We’ll work through it with your tax specialist to quickly determine the most economically advantageous for you. After all, who doesn’t like saving money?

Written by Mark Jordan