Saving Taxes with an S Corporation

An S corporation election allows the shareholders to preserve the benefit of limited liability for the corporate form while at the same time being treated as partners for federal income tax purposes.

Ever wondered why so many small businesses operate as an S corporation? Simple. An S corporation saves business owners big taxes in three separate ways:

Benefit #1: Passthrough Losses

First, as compared to regular corporations (sometimes called C corporations), S corporation owners can use the business’s losses incurred during the early lean years on the owner’s personal returns as deductions. For example, suppose a new S corporation suffers a $20,000 loss its first year and that the corporation is equally owned by two shareholder-employees, Sally and John. Sally and John each get a $10,000 business deduction on their individual tax returns because of the S corporation loss. This $10,000 deduction might save them each as much as $4,000 in federal and state income taxes.

Benefit #2: Lower Payroll Taxes

As compared to almost every other business form, S corporations can save their owners taxes from self-employment or Social Security/Medicare. Suppose, for example, that Andrew, Benny and Chris independently each own businesses that make $90,000 a year in profits. Each business owner may pay $13,000 in income taxes. However, that's not the only tax they have to deal with. Each owner must also self-employment or Social Security/Medicare taxes.

For example, Andrew operates his business as an LLC and therefore pays 15.3%, or roughly $13,500, in self-employment taxes on his profits.

Benny operates his business as a C corporation which pays all of its profits to him as a salary. Accordingly, Benny (through his corporation) also pays 15.3%, or roughly $13,500, in Social Security and Medicare taxes.

Chris’s situation is different. Chris operates his business as an S corporation which means that Chris can split his $90,000 of profits into two payment amounts: salary and S corporation distributions. Suppose that Chris says only $40,000 of his profits are salary and takes the other $50,000 as a "dividend" distrbution. In this case, Chris pays the 15.3% Social Security/Medicare tax only on the $40,000 in salary. Therefore, Chris pays roughly $6,000 in Social Security/Medicare taxes—and annually saves $7,000 in taxes as compared to Andrew or Benny.

Benefit #3: No Corporate Tax

S Corporations also provide a third benefit in the tax arena because they don't pay corporate income taxes. In other words, S corporations get to avoid the well-known "double-taxation" problem. However, the "no corporate income taxes" benefit often isn't a savings for small corporations.

Suppose that two corporations each earn the same pretax profit of $100,000 and are owned by Ms. Davidson who pays the highest federal income tax rate of 35%. One corporation is an S corporation and the other is a C corporation.

The S corporation can distribute the entire $100,000 in profits to Davidson as dividends because there is no corporate income tax. Davidson then pays $35,000 in personal income taxes on the S corporation profits, which means she nets $65,000 in after-tax profits from the S corporation.

In comparison, the C corporation can’t pay the entire $100,000 in profits to Davidson. The C corporation first pays $22,250 in corporate income taxes. When the C corporation pays the remaining $77,750 to Davidson as a dividend, DaVinci pays another $11,663 in 15% "dividend" taxes on the C corporation profits. This means that Davidson nets roughly $66,000 in after-tax profits from the C corporation profits. In this case, DaVinci saves money with a C corporation in spite of having to pay the corporate income tax.

How to Get S Corporation Benefits

To create an S corporation and receive S corporation tax savings, you need to do two things: First, you must incorporate the business either as a regular corporation or as a limited liability company. Second, you need to make an election with the IRS to have the corporation or LLC treated as an S corporation. The S election is made with form 2553, available from the www.irs.gov web site. Note that some states (such as New York) require a separate state S election.

S corporations can save you thousands of dollars each year, but your tax savings can’t start until you elect S corporation status. If S corporation status saves you money, then every moment you delay will cost you hundreds of dollars!
 
Special thanks to Seattle CPA Stephen L. Nelson who contributed to this article. Nelson is the author of QuickBooks for Dummies and edits the S Corporations Explained web site.