Key Takeaways

  • S corp tax advantages include pass-through taxation, avoidance of double taxation, and the ability to save on self-employment taxes.
  • Shareholders can take a reasonable salary plus distributions, reducing overall tax liability.
  • S corps offer limited liability protection like C corps but maintain simpler tax filing and reporting.
  • Additional benefits include deductible business expenses, potential qualified business income (QBI) deductions, and easier transfer of ownership.
  • There are limitations—such as shareholder eligibility, stock class restrictions, and IRS scrutiny on salaries—that business owners must consider.

S corp tax benefits are the tax advantages of forming a subchapter S corporation. This business entity is a corporation that is treated as a pass-through entity by the IRS. This means that the corporation can avoid double taxation since each shareholder reports profits and losses on his or her individual tax return.

To create an S corporation, you must file Articles of Incorporation with the secretary of the state where you plan to establish your business. Like a C corporation, an S corporation must have directors, shareholders, officers, and issue stock. The owners of an S corporation also enjoy limited liability protection. This means their personal assets cannot be seized to satisfy business debts and obligations.

Unlike a C corporation, an S corporation is taxed like a sole proprietorship or partnership. This avoids taxation at both the corporate level and again at the shareholder level. Instead, profits are taxed ones at the individual tax rate rather than at the higher corporate tax rate. 

Is an S Corporation Right for Your Business?

When you're starting a business or considering a new entity for an existing business, considering an S corporation requires examination of tax issues, the number of shareholders, and the level of personal asset protection you desire. An S corporation, along with C corporations and limited liability companies (LLC), is one of the most popular business entities for small business owners.

Establishing an S corporation makes a big impact on how you pay taxes, handle profits, and distribute earnings to shareholders. It's important to understand the pros and cons of each type of business entity to determine which is the best choice for your situation.

An S corporation carries specific ownership restrictions for shareholders as follows:

  • It can only have 100 or fewer shareholders.
  • Shareholders must be individuals or living trusts.
  • Shareholders cannot be non-U.S. residents, multi-member LLCs, or corporations.

S corporations that do not follow these regulations will lose their favorable tax status and be subject to double taxation.

In most cases, those who have a sole proprietorship or general partnership should consider switching to an entity that offers limited liability, such as an S corporation. This will prevent you from losing personal assets if your business is in debt or sued.

S corporations are often a good choice for service-oriented businesses, such as consulting firms. If these types of businesses do not opt for an S corporation, they will be automatically be classified by the IRS as a personal service corporation (PSC). Although C corporations are taxed at a rate of 15 percent for the first $50,000 earned, the PSC tax rate is 35 percent. In most cases, you can save money on taxes in this situation by establishing an S corporation, though your CPA or tax attorney can advise you on the potential ramifications of each business entity.

Understanding How S Corp Taxation Works

Unlike traditional corporations, an S corporation is considered a pass-through entity for tax purposes. This means the business itself does not pay federal income tax at the corporate level. Instead, profits and losses “pass through” directly to the shareholders, who report them on their individual tax returns.

This structure eliminates double taxation, a major advantage compared to C corporations. Under the C corp structure, income is taxed once at the corporate level and again when dividends are distributed to shareholders. With an S corp, income is taxed only once—at the individual shareholder’s rate—which can significantly reduce total tax liability for small business owners.

In addition, S corp owners who work for the business can pay themselves a reasonable salary (subject to payroll taxes) and take the remaining profits as distributions, which are not subject to self-employment tax. This strategy can result in considerable savings when managed properly and in compliance with IRS rules.

What Are the Advantages of Establishing an S Corporation?

In many cases, the advantages of establishing an S corporation are greater than the disadvantages, especially when it comes time to close the business or transfer its ownership. Advantages of S corporations that do not apply to general partnerships and sole proprietorships include:

  • Protection for each shareholder's personal assets, which means his or her home, vehicle, bank accounts, and other property cannot be seized to pay a business debt or obligation unless he or she has provided a personal guarantee for a specific debt. In contrast, the personal assets of owners of sole proprietorships and general partnerships are vulnerable to business obligations.
  • Pass-through taxation, in which S corporations are not subject to federal corporate income taxes or in most cases to state corporate income taxes. In contrast, C corporation profit is taxed at the corporate level when it is earned and at the personal level when it is distributed to shareholders.
  • Shareholders of the S corporation can draw employee salaries as well as receive both dividends and tax-free distributions. This allows an owner who also operates the company to reduce their self-employment tax due while also providing wage deductions for the business.
  • Ownership interests in an S corporation can be freely transferred without adverse tax consequences.

Key S Corp Tax Advantages for Business Owners

S corporations offer several powerful tax benefits that appeal to entrepreneurs and small business owners seeking both protection and tax efficiency:

  1. Avoidance of Double Taxation – As a pass-through entity, the S corp’s profits are only taxed once, at the shareholder level. This can lead to substantial savings compared to the double taxation faced by C corporations.
  2. Reduced Self-Employment Taxes – Business owners can divide income between a salary (subject to FICA and Medicare) and distributions (not subject to self-employment tax). By paying a reasonable salary and taking the rest as distributions, shareholders can legally minimize their self-employment tax burden.
  3. Qualified Business Income (QBI) Deduction – Shareholders of S corporations may qualify for up to a 20% deduction on qualified business income under the Tax Cuts and Jobs Act, offering further tax relief for eligible taxpayers.
  4. Deductible Business Expenses – Ordinary and necessary business expenses—such as salaries, rent, travel, and insurance—can be deducted before profits are distributed, reducing taxable income.
  5. Loss Pass-Through – If the S corp incurs losses, those losses can be used to offset other income on a shareholder’s individual tax return (subject to certain basis and at-risk rules). This flexibility can help reduce personal tax liability during slower business years.
  6. Easier Ownership Transfers – Ownership interests in an S corporation can be transferred without triggering complex tax consequences, unlike partnerships or certain LLCs.

Potential Drawbacks to Consider

While S corp tax advantages are significant, there are limitations and responsibilities to keep in mind:

  • Strict Eligibility Rules – S corps can have no more than 100 shareholders, and all must be U.S. citizens or residents. They may only issue one class of stock.
  • Reasonable Salary Requirement – The IRS requires S corp owners who work for the company to take a “reasonable” salary before distributions. Failure to do so can trigger audits and penalties.
  • State Taxes May Apply – Although S corps avoid federal corporate income tax, some states (such as California, New York, and Illinois) impose entity-level taxes or fees on S corporations.
  • Complex Recordkeeping – S corps must maintain corporate formalities, including regular board meetings, bylaws, and records, to retain their legal and tax status.

Understanding both the benefits and obligations of S corp taxation helps business owners choose the most advantageous structure for their goals.

How to Maximize S Corp Tax Advantages

To make the most of your S corp tax advantages:

  • Work with a tax professional to determine a fair and compliant salary for shareholder-employees.
  • Maintain clear separation between business and personal finances to preserve limited liability protection.
  • Track and document all deductible expenses accurately throughout the year.
  • Reevaluate annually whether your compensation structure and shareholder distributions remain optimal as profits grow.

A tax advisor or attorney can also help you stay compliant with both federal and state regulations while maximizing available deductions.

Frequently Asked Questions

  1. What is the biggest tax advantage of an S corp?
    The primary advantage is pass-through taxation, which allows profits to be taxed only once at the individual level, avoiding corporate-level taxes.
  2. Can I save on self-employment taxes with an S corp?
    Yes. By paying yourself a reasonable salary and taking remaining income as distributions, you may reduce self-employment taxes compared to operating as a sole proprietor or LLC.
  3. Does every state recognize S corps?
    Most states recognize S corporations, but some impose additional franchise or entity-level taxes. Always check your state’s tax rules before electing S corp status.
  4. How does an S corp compare to an LLC for taxes?
    An LLC offers flexibility, but S corps can offer greater payroll tax savings if the owner takes a mix of salary and distributions.
  5. Can foreign investors own shares in an S corp?
    No. S corp shareholders must be U.S. citizens or residents—foreign individuals, partnerships, and corporations are not eligible.

If you need help with understanding the tax benefits of establishing an S corporation, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.