As a business owner, choosing the right business structure to use when you started was one of the most important decisions you had to make. However, it’s always a good idea to periodically revisit that decision as your business grows. For example, as a sole proprietor, you must pay a self-employment tax rate of 15.3% in addition to your individual tax rate. However, if you were to revise your business structure to become an elect S-Corporation, you could take advantage of a lower tax rate.
What is an S-Corporation?
An S-Corporation (S Corp) is a regular corporation whose owners elect to pass corporate income, losses, deductions, and credits through to their shareholders for tax purposes. That is, an S Corp is a corporation or a limited liability company that’s made a Subchapter S election. Shareholders then report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates, which allows S Corp to avoid double taxation on corporate income. S Corps are, however, responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S Corp status, the business must submit a Form 2553, Election by a Small Business Corporation to the IRS, signed by all the shareholders, and meet the following requirements:
- Be a domestic corporation
- Shareholders are individuals, estates, exempt organizations
- Have no more than 100 shareholders
- Have only one class of stock
- No foreign investors
- It must use a December 31 year-end
What are the Tax Advantages of an S-Corp? – Personal Income and Employment Tax Savings
S Corp shareholders can choose to receive both a salary and dividend payments from the business. Dividends are taxed at a lower rate than self-employment income, which lowers taxable income. S Corp shareholders also save on Social Security and Medicare taxes because their salary is less than it would be if they were operating a sole proprietorship.
The split between salary and dividends must be “reasonable” in the eyes of the IRS. Furthermore, some S Corp owners may be able to take advantage of the 20% deductions for pass-through entities as well, thanks to tax reform.
Losses are Deductible
As a corporation, profits and losses are allocated between the owners based on the percentage of ownership or number of shares held. If the S Corp loses money, these losses are deductible on the shareholder’s individual tax return. For example, if you and another person are the owners and the corporation’s losses amount to $50,000, each shareholder is able to take $25,000 as a deduction on their tax return.
No Corporate Income Tax
Although S Corps are corporations, there is no corporate income tax because business income is passed through to the owners instead of being taxed at the corporate rate, thereby avoiding the double taxation issue, which occurs when dividend income is taxed at both the corporate level and at the shareholder level.
Less Risk of Audit
In 2014, S Corps faced an audit risk of just 0.42% compared to Schedule C filers with gross receipts of $100,000 who faced an audit rate of 2.3%. While still low, individuals filing Schedule C are at higher risk of being audited due to IRS concerns about small business owners underreporting income or taking deductions they shouldn’t be.