Wajiha Danish | January 25 2022
A corporation, be it a C-Corp or LLC, pays hefty taxes, not once but twice. First, the corporation’s income is taxed, and then the owners’ dividends. By law, that’s the price you pay for self-employment; double taxation. Is there a way out? For some, yes! These include domestically incorporated small businesses, having less than 100 shareholders and one class of stock. They are the firms eligible to get taxed as S-corporations. Does your business classify as one? If yes, best to switch from LLC or C corp to S-Corp as it saves you from double taxation.
Moreover, the tax benefits of S corp go beyond that. You pass the self-employment tax too. That’s why S-corps are often called “pass-through” entities.
See Also: How to Get S-Corp Status?
To clear the air, you can’t choose to become an S-corporation at the time of formation. In other words, you can’t form it by filing a certificate to the Secretary of State. An S-corp is not a type of business entity, like C-Corp or LLC; it is a kind of tax classification, also called Subchapter S Election. You get this by submitting a Form 2553, Election by a Small Business Corporation, to the IRS, not the Secretary of State. Once approved, the business entity gets to have the best of both worlds; the benefits of incorporation and the perks of partnership.
An S corporation works the same way as any other business entity. It must have a board of directors, a corporate office, and a management structure. Yet still, for all the corporate perks, it gets taxed as a partnership.
An S-Corp can classify its income into two categories; salaries and distributions. Yes, you pay self-employment taxes on the salary portion. However, the distributions pass the federal corporation tax. You only pay ordinary income tax on it. Hence, depending on how you divide the two, you can save loads of money.
Tax saving is the main reason why small businesses ditch the C-Corp or LLC tag for an S-corporation status. Under the S tag, you won’t have to pay federal taxes at the corporate level. That’s no small thing!
For aspiring start-ups, S corp tax savings lets you better reinvest finances and accelerate growth. Undoubtedly, a perk to capitalize upon, at least till you break even.
By dispersing the money as salary or dividend, you lower your liability for self-employment tax. Let’s understand this further by breaking the tax benefits of S-corporation into three; double taxation, self-employment tax, and health premiums.
As we know, C-Corporations and LLC are taxed twice. First at a corporate level and then on personal. The only way out is to become an S-corporation. As it passes the majority of its income directly to shareholders, the distributed sum evades federal corporate taxes. The chunk of the profits is only taxed once and at individual income tax rates.
By dividing business profits into salaries and distributions, an S-corporation pays lesser self-employment tax. Only the wages get taxed, not the distributed sum. That gives small businesses and entrepreneurs a massive advantage. Here’s how it works;
Say you co-own a small business, filed as an S-corporation. You are the CEO and Co-Founder with 50% shares in the entity. Now assume it made a net profit of $250,000 in 2021. As the CEO, you made $75,000 in salary and received 50% of the net profit, or $125,000.
In this scenario, being an S-corp, you would pay the self-employment tax only on $75,000, while $125,000 would be federal tax-free.
The S-corp pays payroll taxes only on wages. However, you can get an exemption there too. How? Through health insurance premiums.
Let’s take the previous example. Say $15,000 from $75,000 annual salary accounts for health premiums. Even though they will get subjected to income tax, they get exempt from self-employment tax. Thus, the salary subjected to 15.3% self-employment tax further drops to $60,000.
In addition to the tax benefits of S-corp, you get more leniency too. Unlike C-corps that have to file taxes quarterly, an S-corp only files taxes once a year like individual taxpayers. Moreover, they are also permitted to request a six-month extension like ordinary folks.
Generally, the 15th of the third month, March, is the due date to file taxes. However, an S-corp can request a six-month extension by filing Form 7004: Application for Automatic Extension of Time to File Certain Income Tax.
Being an S-corporation saves you loads of money in taxes. However, there’s a catch. There is a risk of abuse. As distributions get passed through self-employment tax, the enticement often lures business owners to tilt the salary-distribution scale towards the latter.
However, despite the benefits, there’s one thing to consider. The IRS keeps a close eye on the S-corporations. The second they feel the distributions are getting the lions’ share or salary look too unreasonable, they get triggered. The result? IRS inquiry, audit, and penalties.
Thus, play the game right or lose it all. S-corp tax savings can make a huge difference, especially for small start-ups, so best to maintain the right balance.
Want to know what’s okay and what’s not? Turn to tax experts and file returns smartly !!!
Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.