What is the biggest tax benefit of choosing an S-corporation?
Perhaps the most significant benefit of an S-corporation over a C-corporation is the avoidance of double taxation.
The net income of a C-corporation is taxed at the corporate level, and dividends distributed to shareholders are then taxed again at the shareholder level. In an S-corporation, by contrast, the corporation’s net income passes directly to the shareholders, who report it on their personal tax returns. This avoids the double taxation that applies to C-corporations.
How does filing taxes work with an S corporation?
S-corporations must file Form 1120-S, U.S. Income Tax Return for an S-corporation, with the IRS each year. The deadline generally aligns with the standard March filing deadline for S-corporations operating on a calendar year.
In addition to the federal return, most states require S-corporations to file a state corporate tax return.
Generally, no federal income tax is due at the corporate level because S-corporations are pass-through entities. Each shareholder receives a Schedule K-1, which reports their share of the business’s income, losses, deductions, and distributions. Shareholders then report this information on their individual tax returns and pay taxes on their share of the income.
Am I required to send a W-2 to shareholders who work for my S corporation?
Yes. S-corporations are generally required to pay reasonable compensation to shareholders who work for the business. This compensation is typically paid through payroll, which means issuing a Form W-2 to those shareholders.
The amount of reasonable compensation depends on factors such as:
- The shareholder’s role and duties,
- The company’s profits, and
- The value of the company’s capital or equipment.
If compensation is set too low, the IRS may reclassify part of the shareholder’s income as wages and assess payroll taxes.
How is my self-employment tax liability affected if I form an S-corporation?
One of the unique advantages of S-corporations is that they can help reduce self-employment tax liability in certain situations.
If you operate as a sole proprietor, all net profits are generally subject to self-employment taxes. However, in an S-corporation, the business’s net profits are not subject to self-employment taxes.
Only the wages you receive as an employee of the S-corporation are subject to employment taxes, while the remaining profits that pass through to your personal return avoid those taxes.
Choosing an appropriate amount of W-2 compensation is important to ensure compliance with IRS requirements.
What potential administrative expenses might I face as the owner of an S-corporation?
While operating as an S-corporation may provide meaningful tax benefits, it also comes with additional administrative obligations.
A sole proprietor reports business income directly on their personal tax return, while an S-corporation files a separate business return. Because of the reasonable compensation requirement, an S-corporation is often required to run payroll, which increases administrative costs compared to a sole proprietorship.
Sole proprietorships may be simpler to operate, but they often are not the most efficient structure for taxes and do not offer limited liability protection. Although the administrative expenses of an S-corporation are closer to those of a partnership or C-corporation, the tradeoff can be worthwhile for the potential tax and liability benefits.
Understanding how S-corporations are taxed can help you decide whether this structure aligns with your financial goals. Whether you are considering an LLC, partnership, S-corporation, or C-corporation, Rocket Lawyer business formation specialists are here to help. If you have more questions about the tax benefits for each type of business structure, or what might be best for your business, reach out to a Rocket Lawyer network attorney for affordable legal advice.
Please note: This page offers general legal information, not but not legal advice tailored for your specific legal situation. Rocket Lawyer Incorporated isn't a law firm or a substitute for one. For further information on this topic, you can Ask a Legal Pro.
