Tax Advantages of S Corp: Everything You Need to Know
There are many tax advantages of an S Corp that you should think about while incorporating your business. 3 min read
2. Tax Advantages
3. S Corp Risk
Tax Advantages of an S Corp
There are many tax advantages of an S Corp that you should think about while incorporating your business. An S Corp is created by filing Articles of Incorporation with the Secretary of State, similar to that of a C Corp. The S Corp, also similar to a C Corp, issues stock, hires a board of directors, employs officers, and has at least one or more shareholders who are the owners of the corporation.
The owners, referred to as shareholders, have the same limited liability protection as shareholders in a C Corp. Therefore, the S Corp’s shareholders cannot be held personally liable for the debts and losses of the business. Such personal assets include the person’s bank account, home, car, and other personal assets. There are some exceptions to this rule, particularly for shareholders actively engaging in fraud or other illegal actions, or shareholders who offer a personal guarantee over a business loan.
While the C Corp has the significant disadvantage of double-taxation, the S Corp avoids this tax implication, which is one of the biggest tax benefits of operating an S Corp. With that said, some states require S Corps to pay additional fees and taxes. The State of California requires an S Corp to pay a tax of 1.5% on its income with a minimum annual amount of $800.
While there are many advantages to the S Corp, there are some key tax advantages that you should keep in mind when incorporating your business, including:
• Shareholders can pay themselves a reasonable salary for the work conducted for the business
• Shareholders can receive tax-free dividends
• Income splitting potential between shareholders and employees
The most important tax benefit is the pass-through taxation feature. An S Corp doesn’t pay federal taxes at the corporate level. Instead, the profits of the business pass through to the shareholders who report it on Form 1040 – individual tax return.
Another tax advantage is the fact that shareholders in the S Corp can also act as employees of the business; if they do, they must pay themselves a reasonable salary. The shareholders can also receive dividends from the S Corp, as well as other distributions, all of which are tax-free. As such, shareholder/employees can reduce their tax liability by paying themselves via dividends and wages, thereby reducing the amount of payroll tax on wages earned.
Another tax advantage of the S Corp is that the business can use a cash method of accounting, as opposed to the accrual method that most C Corps are subject to. With that said, a small corporation should have gross receipts of no more than $5 million. If the S Corp has inventory, then it might still need to use the accrual method of accounting. There is also a potential for significant income splitting among shareholders and employees.
Overall, the S Corp is good for businesses that provide some sort of service, will not have high start-up costs, will not have to make any significant equipment purchases, and will be able to earn a decent profit without having to spend a lot of money or input too much effort.
S Corp Risk
While the S Corp has many tax benefits, the IRS closely monitors them due to the potential for abuse. Shareholder/employees who pay themselves a salary for their work must ensure that they are paying themselves an appropriate salary. Since dividends are tax-free, most shareholder/employees will want to pay themselves more in dividends and less in salary to avoid paying tax. However, this will likely cause an issue and the IRS will be quick to have you readjust your compensation and pay taxes on the appropriate amount of money that you should be paying yourself.
For example, if you make $500,000 in a taxable year, but only pay yourself $20,000 in income, this will likely trigger an IRS inquiry, since you are avoiding paying a significant amount of self-employment tax. This could also cause potential penalties if the IRS believes that you are intentionally trying to avoid paying taxes.
If you need help learning more about S Corporation taxes, or if you need assistance filing state or federal taxes for your S Corp, 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.