Forming an S corporation can provide significant tax savings compared to operating as a sole proprietorship, partnership, or regular C corporation. S corps allow business owners to take advantage of pass-through taxation, business expense deductions, and strategic tax planning.
Pass-Through Taxation
One of the biggest advantages of an S corp is pass-through taxation. Here’s how it works and the potential tax savings:
Avoiding Double Taxation
Regular C corporations are subject to double taxation:
- The corporation pays corporate income tax on its profits.
- Shareholders pay individual income tax on dividends.
An S corp avoids this by passing income directly to shareholders to report on their personal tax returns. The S corp itself is not taxed.
Taxed at Individual Rates
By passing income to shareholders, S corp owners can take advantage of lower individual income tax rates rather than higher corporate rates (capped at 21%).
For example, as an individual you may pay only 15% tax on a certain amount of business income. A C corp would pay 21% on that same amount.
Shareholder Salaries
S corp shareholders must take “reasonable compensation” from the business as a salary, which is subject to payroll taxes. But additional distributions can be taken free from payroll taxes.
Significant Savings
The overall tax burden for an S corp is reduced by avoiding double taxation and having business income taxed at individual rates. The tax savings can be significant for profitable businesses.
Business Expense Deductions
As an S corp, many common business expenses can be deducted directly on your personal tax return:
- Health insurance – Premiums paid for yourself and employees are fully deductible.
- Meals & entertainment – Subject to limits, you can deduct meals, entertainment, vehicle costs, etc.
- Retirement plans – 401(k)s, SEP IRAs, SIMPLE plans, and other retirement contributions are deductible.
- Rent & lease expenses – Office rent, equipment leases, storage fees, etc. can be deducted.
- Wages paid – Salaries, bonuses, and other compensation provided to employees are deductible expenses.
- Other ordinary expenses – Things like office supplies, utilities, software, accounting fees, advertising, etc. can all be deducted.
Being able to deduct these on your personal return provides significant tax savings for S corps.
Strategic Tax Planning Opportunities
Beyond basic deductions, additional tax planning with an S corp can minimize your tax burden:
Owner Salary vs. Distributions
As an S corp shareholder, you only pay payroll taxes on salary. Additional earnings taken as distributions aren’t subject to payroll taxes.
- Take a “reasonable” salary based on your role and duties, then remaining profits as distributions.
Tax-Free Fringe Benefits
Certain fringe benefits like health insurance can be deducted by the S corp as a business expense but provided tax-free to you as the owner.
Retirement Funding Options
S corps allow flexible retirement plan contributions for owners and employees. Choose the right options like 401(k), SEP IRA, SIMPLE IRA, etc.
Fiscal Year vs. Calendar Year
You can choose a fiscal year rather than calendar year for your S corp reporting. This allows flexibility in timing income and expenses to minimize taxes.
Professional Guidance
Consult a tax advisor to maximize the planning opportunities available with an S corp. There are many ways to reduce your tax burden.
Properly leveraging an S corp structure takes expertise, but the tax benefits can be significant. Work closely with advisors to put the right tax planning in place.
Final Tips
- Determine if S corp status makes sense for your business. Consult a tax pro.
- Elect S corp status when forming your LLC or corporation by filing Form 2553.
- Follow all S corp requirements. Improper setup can jeopardize your S corp status.
- Handle payroll, record keeping, tax payments, and filings correctly.
- Evaluate your S corp status each year. Be prepared to switch back to a C corp if beneficial.
