What is an S-Corporation?

According to the IRS:

“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.”

Now you’re probably asking what that means for your business? Or maybe you’re asking what’s the point of this article if we’re still going to make you read IRS legalese? Fair point, but bear with us and let’s get into it.

For starters, most businesses can elect to be taxed as an S corporation, even if they are not currently organized as a corporation at all. Check out our article, Who Can Make the S-Corp Election to learn more. If your business is an LLC or sole proprietorship, you can probably continue to operate your business almost exactly as you have, but are likely eligible to elect to be taxed as an S-Corp, and you may save substantial amounts of tax by doing so.

But let’s get back to the questions at hand… What is an S Corporation? What does the S even stand for? And what is all this talk about passing things on to shareholders and avoiding double taxation?

What’s the meaning of the S in “S-Corp”?

Like most people, you may have thought the S in S-Corp stands for “small business,” and you would be kind of correct, although ‘technically’ wrong; allow us to explain.

As we said before, an S-Corp is a tax designation. It can be made by small businesses, but it isn’t actually a business entity type, and you can’t ‘incorporate’ as an S corporation (see What is the best entity type for S-Corps? ). An S-Corp is limited to 100 owners, so while every S-Corp is a small business, not every small business files as an S-Corp. Just like every tequila is a mezcal, but not every mezcal is a tequila. Or is that vice versa? We digress.

So if the S doesn’t technically stand for small-business then what does it stand for? You may be surprised that it doesn’t stand for a word at all! It simply refers to the location in the Internal Revenue Code, “Subchapter S”, where the laws and requirements regarding the S-Corp election can be found.

Additionally, the S-Corp election allows small businesses to avoid paying taxes at the entity level, unlike their big brother, the C-Corp. S-Corps pass profits or losses through to the shareholders who then report it on their personal income tax returns. You may have heard your bookkeeper or small business accountant refer to this concept as avoiding double taxation (thank you IRS, but I think I’ll pass on seconds). LLCs and partnerships already don’t pay the entity-level corporate tax so chances are this benefit won’t apply to your small business, but it’s definitely an important one if you’re comparing the S-Corp to a C-Corp.

But who has time to decipher all of that legal jargon? We do! So let’s dive further into exactly how this Subchapter S can save your small business money.

What does the S-Corp election actually do?

When an S-Corp is formed, owners are considered employees of the business, and this structural change results in money saving benefits for small businesses. For starters, this means that owners are paid a salary and have income and payroll taxes withheld. In turn, small business owners who have made the S-Corp election pay Social Security and Medicare taxes only on their salary rather than 100% of business profits. All other income is paid through “distributions” to shareholders, which are not subject to self-employment tax. How much savings does that translate to? The current self-employment tax rate is 12.4% for Social Security and 2.9% for Medicare, that’s a combined 15.3% that small business owners can save on taxes!

You may be thinking, “So can I pay myself $0 and never pay self-employment tax!?” We hate to say it, but unfortunately the IRS already thought of that. Thus, any employee who is also a shareholder in the company must be paid “reasonable compensation” before receiving distributions. Take a look at our article on reasonable compensation for S-Corps to find out what “reasonable” means and how determining compensation impacts the accounting and taxes for your small business.

Wondering how the S-Corp election could affect other aspects of your small business taxes such as health insurance, bookkeeping, deductions, or retirement planning? S-Corps do have particular laws surrounding these categories and a CPA Firm or accounting service specializing in small business taxes will be the best way to ensure you’re using every applicable tax saving strategy.

Lastly, It’s especially important for S-Corps to have excellent bookkeeping habits or to hire a bookkeeper and/or accounting service for small businesses because S-Corps have ongoing requirements to maintain and the IRS can revoke S-Corp status immediately any time a company fails to meet them. How to Keep S-Corp Status gives a breakdown of the topic.

Now that you’ve got the basics down on S-Corps, check out Who Can Make the S-Corp Election to learn more about the requirements of becoming an S-Corp.