1. How an S Corp Can Reduce Your Self-Employment Taxes
2. Pass-Through Tax Treatment of S Corporations

How an S Corp Can Reduce Your Self-Employment Taxes

Understanding S corp and self-employment tax is important when you're a self-employed business owner. Organizing your business as an S corporation can help reduce Medicare and Social Security taxes. Those who are self-employed typically have to pay higher self-employment taxes, which include Medicare and Social Security amounts. A standard employee at a company wouldn't have to pay as high of tax rates as someone who is self-employed. However, organizing a business as an S corporation can help reduce some of the required tax amounts. 

When you do opt to set up your business as an S corp, you may find that the IRS reviews your taxes more closely. S corporations offer tax advantages that can help reduce the overall tax liability, even when your business is generating the same amount of net income. One of the tax advantages of an S corporation is pass-through taxation, which means that the corporation's profits pass through the business to the shareholders. Those profits are reported on the personal tax returns of the shareholders. Unlike other business entities, S corps aren't taxed on corporate income.

Some of the key distinctions between business entities and taxation relate to the owners of the business. For example, in a partnership, all income that will be allocated to one of the business partners is automatically treated as self-employment income. Any income in this category is subject to all required self-employment taxes, including Medicare and Social Security employment taxes. The owners of an S corporation can receive payments as dividends for ownership or compensation in the form of a salary for work provided to the business. The corporate roots of an S corporation are partially maintained.

Pass-Through Tax Treatment of S Corporations

A traditional corporation has a structure with two taxation tiers:

  • The first tier is for the business itself, which is its own entity that must pay taxes on all income and file its own tax return.
  • The second tier is for the shareholders; all income distributed as dividends to the shareholders in the business will be taxed once again. However, this additional tax will have the qualified dividend tax rates applied, which are favorable rates.

Many smaller companies don't operate as a separate business entity. Instead, a small business might operate as a sole proprietorship, with all income being reported and taxed on the owner's personal tax returns. In a similar way, many businesses formed as partnerships include multiple sole proprietors who operate the company. Applying the complicated two-tier tax structure that impacts corporations would be too complex and wouldn't represent the reality of the business, which includes several individuals working together on a joint business venture.

Tax codes accommodate this fact of small businesses by allowing partnerships to take advantage of pass-through taxation. Although a partnership does have a legally separated business entity, the income generated wouldn't be double-taxed. Instead, all profits are passed through the business to the owners, who report it on their personal tax returns. By allowing for this option, the corporation double taxation is eliminated for partnerships.

However, some business owners don't want to form their companies as partnerships or LLCs taxed as partnerships. A business owner may worry about the exposure to liability that can come with forming a partnership. In some cases, it's important that the business is easy to transfer, especially in small parts. It's not as easy to transfer partial interests of an LLC or partnership as it is to transfer the shares of a corporation. For succession planning and other reasons, transferability can be a major concern.

In order to accommodate these needs, the tax code does allow a corporation to elect for taxation as an S corporation. When a business elects for treatment as an S corporation, it carries the legal treatment of a standard corporation, with all necessary requirements in place to form and operate a corporation but has pass-through taxation privileges that are similar to how a partnership would be taxed. 

As a result, a business can take advantage of the benefits of a corporation set up, including limited liability and the ability to transfer ownership, along with the pass-through taxation that eliminates two-tier or double taxation.

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