What Is an S Corp and Is It Right for Me?

What is an S corp?

An S corp is a tax designation that allows business profits to pass directly to owners' personal tax returns, avoiding corporate-level taxation. Unlike C corporations, which pay corporate income tax before distributing profits to shareholders, S corps avoid this double taxation. Both corporations and LLCs can elect S corp status by filing Form 2553 with the IRS.

To be an S corp, your business must:

• Have no more than 100 shareholders
• Not have non-resident alien shareholders
• Not have owners that are corporations or partnerships
• Have only one class of stock

Electing S corp. taxation involves filing Form 2553 with the Internal Revenue Service (IRS). You must file the form within IRS deadlines.

Advantages of an S corp for LLC owners

When an LLC is taxed as a sole proprietorship or partnership, the owners are considered self-employed. Owners will pay Social Security and Medicare taxes (known as self-employment taxes) on their full share of the company's profits.

If your business earns significant profits, you may save on self-employment taxes by choosing S corp taxation instead.

S corp owners who work in the business can be company employees, and they must pay themselves a reasonable salary for the work they do. Like all employees, they'll pay Social Security and Medicare taxes on that salary, but additional company profits won't be subject to these taxes.

Owner-employees can also participate in company benefit programs, including 401K and profit-sharing plans. However, some employee benefits like medical and life insurance can be taxable if an employee owns more than two percent of the company.

There are a few main disadvantages for LLC electing S corp status.

• Additional paperwork: You must elect S corp status with the IRS and run payroll with tax withholdings.
• IRS scrutiny: The IRS closely monitors whether owner-employees pay themselves a fair and reasonable salary.
• Cost vs. benefit: For small businesses with few profits, these added burdens can outweigh the tax savings.

C corp vs. S corp tax advantages

While large companies are typically C corporations, small business owners often prefer S corp taxation because their profits aren't taxed at both the corporate and shareholder levels. However, S corp taxation isn't ideal for every business.

A company might benefit from C corp taxation if:

• It's a startup hoping to attract outside investment. Institutional investors usually prefer C corporations.
• It plans to keep money in the business to fund future growth. C corp shareholders only pay tax on money distributed to them, whereas S corp owners pay tax on all company profits.
• It doesn't meet the requirements for S corp taxation.

The tax advantages of an S corp depend on several factors, including your business' size, profitability, and structure. It's best to review your options with a tax professional who can help you make the right choice for your situation.