Let’s discuss the tax benefits of S corporations. S Corps, also known as S corporations, is an IRS election made by corporations or LLCs (limited liability companies) that governs the way these entities are taxed by IRS (and often time State) tax authorities. They are named after Subchapter S of the Internal Revenue Code, which outlines the rules and regulations governing these types of companies. Unlike traditional corporations, S Corps have certain tax advantages that can make them a more attractive option for small businesses.
S Corporations Versus C Corporations
One of the main benefits of S Corps is that they are taxed differently than traditional corporations. Unlike traditional corporations, which are taxed at the corporate level and then again at the individual level when profits are distributed to shareholders as dividends, S Corps are only taxed at the individual level. This means that profits and losses are passed through to the individual shareholders and reported on their personal tax returns. This can result in significant tax savings for the business and its shareholders.
For example, let’s say a traditional corporation has $100,000 in profits in a given year. The corporation would first be taxed at the corporate level, which could be as much as 21% depending on the amount of profit. This would leave the corporation with $79,000 in after-tax profits. If the profits were distributed to shareholders as dividends, the shareholders would be taxed again on their personal tax returns. Depending on their individual tax rates, this could result in an additional tax bill of up to 23%. This leaves the shareholders with a total of $60,830 in after-tax profits.
In comparison, an S Corp with the same $100,000 in profits would only be taxed at the individual level. The profits would be passed through to the shareholders and reported on their personal tax returns. Depending on their individual tax rates, this could result in a tax bill of up to 37%. However, because the profits were only taxed once at the individual level, the shareholders would end up with a higher amount of after-tax profits compared to the traditional corporation.
S Corporations Versus LLCs Taxed as Sole Proprietors
S corporation owners (shareholders) can receive income in the form of salaries and bonuses, which are subject to payroll taxes. They can also receive distributions, which are not subject to payroll taxes. This can provide significant tax savings compared to sole proprietorships, where the owner must pay both income and payroll taxes on all profits.
Since the tax savings are dependent on the level of salary that the owner earns from the S Corp, the IRS requires a reasonable salary to be paid. It’s best to document this salary annually to justify the wages paid to the owner. We’ve seen some clients save thousands of dollars in Social Security and Medicare taxes by employing this strategy.
Another advantage of S Corps is the ability to elect into state level Pass Through Entity Taxes (PTET). Since 2018, many taxpayers have been limited to deducting no more than $10,000 in state & local taxes as itemized deductions. At last count, about 30 states have created a PTET as a workaround for the 2018 tax law changes. The PTET allows you to shift the burden of state taxes based on business income to the S Corp which allows you to receive a full deduction. This can be a powerful tax savings opportunity. However, each state has implemented the rules differently. So it’s important to review state limitations before opting in to this entity level tax.
Overall, the tax benefits of S Corps can be significant for small businesses. They can result in more after-tax profits for the business and its shareholders.