S Corporations – Like a Crazy Girlfriend That’ll Slash the IRS’s Tires
- Anthony J. Charles, EA
- Nov 8, 2024
- 11 min read
Updated: Jan 8, 2025
This article is for self-employed people or those who own an LLC and don’t know what to do with it, but mostly – it’s for businessowners who are unaware of the tax benefits of owning their own S corporation.
tldr: S corporations can save small businessowners THOUSANDS in taxes but cost about $2,000 a year for a professional to handle the extra administrative burdens that come with it. There is a breakeven point for each business to consider.
Part I – How S Corporations Save Taxes
Yes, taxes are stupid. They are boring. Thinking about them makes most people’s head hurt. For some, it’s like a kick in the nuts. Those are the people I serve! Having an LLC on its own will not save you on taxes. You can take the same deductions you would as a sole proprietor. There is no difference. Period. I don’t care what you heard on Tik Tok.
Okay, are you ready? For all those self-employed or small businessowners (let’s just call them “taxpayers”), before the government even gets started, they will hit your earnings with a whopping 15.3% self-employment tax (we’ll call it “SECA” – for Self-Employed Contributions Act). All your self-employment income is subject to it. If you make $100,000, you will pay $15,300 in SECA. Then they tax everything again at your marginal tax rate. SECA is made up of 6.2% Social Security Tax and 1.45% Medicare Tax. That adds up to 7.65%, which is half of 15.3%. So, who pays the other half? You do! If you worked for The Man, you would get 7.65% of your wages withheld, and The Man would have to pay for the other half. Since you are self-employed, you pay both sides. 15.3%. Sucks, doesn’t it?
Enter, the S corporation. Same scenario. Your S corporation earns $100,000. We are going to take $50,000 and pay you a salary. Why? Because tax law requires S corporation shareholders who are also employees take a “reasonable salary.” I can write an entirely separate blog post about what the word “reasonable” means. How exciting does that sound? All right, focus! You will need to do payroll for that $50,000 and pay 15.3% in FICA taxes (Federal Insurance Contributions Act), which is the same thing as SECA but with a different name. Employer pays half. Employee pays half. With an S corporation, you are both the employer AND employee. The good news is that you don’t need to pay as much in Estimated Taxes since a significant portion of your tax bill has already been paid through withholding. So, what happened to the other $50,000 that you didn’t pay in salary? The remaining $50,000 is business income, and that’s not subject to that 15.3% crap. You literally just saved $7,650 in taxes.
That’s how an S corporation saves you on taxes – by splitting your income into two categories that are taxed differently. What’s the catch, you ask? Well, a few things. Remember that “reasonable” salary you need to take? You cannot simply pay yourself a couple dollars and save on FICA taxes. You need to pay yourself what the market would pay someone else with your education, experience, and job description. Secondly, you need to run payroll for yourself and file the necessary employment tax returns (hint: you are going to hire a professional to do this). Thirdly, S corporations need to file their own annual tax return. Altogether, you are looking at spending about $2,000 per year to maintain an S corporation. The breakeven point for when an S corporation makes economic sense depends on which state you live in and your own individual financial situation. For Hawaii, I tell people whose businesses make at least $60,000 in profit to consider an S corporation. In other situations, your breakeven point might be as low as $30,000 profit.
Part II – The Technical Details
An S corporation is not a type of business structure. It is a tax treatment. Its rules are governed by Subchapter S of the Internal Revenue Code (IRC). When you incorporate or organize your business in your state, you become a corporation or LLC, respectively. The IRS has a default tax treatment for each type of entity. If you are a corporation, you will be treated as a C corporation, which has double taxation. If you are a single-member LLC, the IRS will treat it the same way girls treated me in college – it will be ignored. The IRS calls it a “disregarded entity.” Any of its profits or losses will pass through to your Form 1040. Disregarded entities do not file their own tax returns. If you are a multi-member LLC, the IRS will tax it as a partnership, which does need to file its own tax return. Even an LLC owned by a married couple is considered a partnership and must file a separate tax return. There is an exception, but only for couples living in a community property state. An LLC is quite flexible in how its income is taxed. For the most part, you can choose, or “elect”, the tax rules your company needs to follow. Choosing to be taxed as an S corporation is what those in the tax business call an “S election.”
You cannot make an S election without having an existing corporation or LLC. That’s like filing a tax return for someone who hasn’t been born yet. Don’t get any ideas, Hawaii! Oh yes, corporations and LLCs are legally treated as persons. They can own and dispose of property, sue and be sued, file and pay taxes, hire other people, issue and take on debt, and enter contracts. They cannot vote, but they can donate money to their favorite politicians. Isn’t that adorable? The good news is that the law makes a distinction between corporations and their owners. That distinction naturally leads to limited liability for the owners.
But I digress, let’s say you form your LLC on January 1, 2025. If you want to be treated as an S corporation on the first day of your LLC’s life, you need to file your S election on or before the 15th day of the 3rd month of its 1st tax year (March 15, 2025). Otherwise, if you file your S election between March 16, 2025 and December 31, 2025, your LLC will become an S corporation at the beginning of its next tax year (January 1, 2026). There are ways around these deadlines, but I will mention that later.
To be eligible for S corporation treatment, your company must:
1) be a domestic corporation or LLC,
2) have no more than 100 shareholders,
3) have only US citizen and resident alien shareholders,
4) have shareholders that are individuals or estates/trusts,
5) not be a bank or insurance company, and
6) have only one class of stock
All shareholders or members must agree to the S election. It’s not based on a majority vote of shareholders. It must be a unanimous vote. S elections are made using a 5-page document called Form 2553, Election by a Small Business Corporation. An S election is tied to the company’s Employment Identification Number (EIN), which is like a Social Security Number (SSN) for a business entity. If you have a disregarded single-member LLC that becomes an S corporation in the middle of the year, then you will need to report your income on your personal tax return up to the date before the S election’s effective date. Starting on the S election’s effective date, all income of the S corporation shall be reported by filing Form 1120-S, U.S. Income Tax Return for an S Corporation, by the 15th day of the 3rd month following the end of its tax year (normally, March 15). You can get a 6-month extension to September 15.
Short tax years of less than 365 days are typical during the first year of the S corporation’s life, so you may need to keep track of business income and expenses starting in the middle of the year when the S election takes effect. In that case, you will have two profit and loss (P&L) statements: one for yourself, one for the S corporation.
S corporations do not pay income taxes. They report their income and expenses on Form 1120-S, which will flow-through to their shareholders. The shareholders are responsible for making quarterly Estimated Tax payments on their corporate distributions. Note: many sources incorrectly refer to S corporation distributions (taking money or property out of the business) as “dividends.” Dividends have a specific definition in tax law. They are reported on a different part of your tax return and can be taxed differently. Qualified dividends are treated preferentially as long-term capital gains. The distributions you receive from an S corporation are treated as ordinary income, taxed at your marginal tax rate. The only preferential treatment they receive is they are not subject to SECA/FICA tax.
You, personally, will pay income tax on the corporation’s pass-through income whether you take it out of the corporation or not. That’s why it’s called an “income tax” and not a “distribution tax.” Since I’m on another tangent, dividends are distributions of earnings and profit from a C corporation. They are taxed both when (1) the money is made, and (2) when you receive them from the C corporation. In the first instance, the C corporation pays a flat 21% corporate tax on its income. In the second instance, you (whoever gets paid) pay the tax on the dividend depending on if it’s classified as ordinary or qualified.
Your S corporation return needs to be done before your personal tax return. The S corporation will spit out two things needed for your personal tax return: (1) a W-2 for your salary, which goes on your Form 1040, and which the S corporation will completely write off as a business expense, and (2) a Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., which shows your share of the S corporation’s “income, deductions, credits, etc.” that will pass-through to your tax return and upon which you will pay income taxes (but not SECA/FICA). Think of the K-1 as a fancy 1099 for businessowners.
Big concept here: the legal structure of the business entity you formed with the state is not changed with the S election. It is simply treated differently for tax purposes. You are treated by the IRS as a corporation. Even if you have an LLC, which is owned by “members”, for tax purposes, you will be referred to as a “shareholder” and will base your number of “shares” on the percentage of the LLC that you own. Just remember, legal classification is not always the same as tax classification. Legal classification determines how your entity is structured, the titles of the persons who own/run it, and most importantly – the legal liabilities its owners face while conducting business. Tax classification determines which form is used to file your taxes, who pays the taxes, how much they pay, and the rules the taxpayer and the IRS must follow.
Things Prospective S Corporation Owners Should Know
1. Corporate personhood – the concept in law that treats corporations or LLCs as distinct entities, separate from their owners, and as a legal person.
2. Gross receipts (sales or revenue) – all money that is handed over to you from conducting your trade or business.
3. Cost of Goods Sold (COGS) – if you sold an apple, then COGS is how much it cost to buy the apple from the wholesaler; not used by all businesses.
4. Gross Profit (Gross Margin) – Gross receipts minus COGS – I bought an apple for $1 and sold it for $3. My Gross Profit is $2.
5. Operating Expenses – business expenses incurred in the line of business – (receipts are not needed to claim deductions… only needed to substantiate deductions in case of an audit.)
6. Operating Income (Earnings or Profit) – Gross profit minus operating expenses – what is left over. I paid $1 to advertise my apple for sale. My operating income is $1. Usually excludes ITDA (Interest, Taxes, Depreciation, and Amortization).
7. Loss – when profit or gain is less than zero.
8. Profit & Loss Statement (P&L) – the document that lists your gross receipts, COGS, gross profit, expenses by category, and net income. ALL self-employed and businesses must keep records and make a P&L each year (ideally, monthly) – it is THE DOCUMENT that is needed to prepare your tax return.
9. Balance Sheet – also needed for S corporation tax return preparation – a summary of your company’s assets, liabilities, and equity.
10. Depreciation – an expense allocated for the theoretical wear, tear, and obsolescence of a fixed asset. If allowable, you must deduct it on your tax return, and you will end up paying taxes on it eventually when you sell it (called “depreciation recapture”). Do not confuse with the term “appreciating asset” which is one in which market value increases over time. Even appreciating assets can be depreciable.
One more thing: gross receipts are not just the total of all Forms 1099-NEC given to you. You also need to count money you earned that wasn’t reported on a 1099. Don’t forget about your legal responsibility to issue 1099s to people who need them. Most businesses forget about this or don’t even realize that it’s required. I will write more about 1099s in another article.
Part III - Late S Elections
Okay, you missed the deadline. You’re screwed, right? Well, not necessarily. Rev. Proc. 2013-30 is the authority for the IRS to grant late S election relief to taxpayers who missed the normal deadline but did everything else correctly. The latest you can request a retroactive S election is 3 years and 75 days after the desired effective date. Again, you can only use this if your only mistake was not filing the S election paperwork on time. The company must have met the general qualifications, filed all business tax returns, and paid reasonable compensation to its shareholder-employees through payroll. I personally benefitted from late election relief. My accountant who formed my wife’s business never filed her S election; in fact, they never even applied for an EIN. My next accountant filed our S corporation returns for two years using the wrong EIN; one which did not have a valid S election tied to it. After teaching myself, I ultimately filed a late S election over two years after the business entity was formed.
What does all this brouhaha mean to you? Let’s say you have been doing business under an LLC you created a couple years ago. Last year, you filed your taxes on Schedule C, Profit and Loss for Business on your Form 1040. This year, your business has been doing well. You are projecting a net profit of $75,000 by the end of the year. It’s November, and after reading this blog article, you call your handsome tax accountant, and I advise you that you would benefit from a late S election, retroactive to January 1, 2024. We file the paperwork, and on January 10, 2025, you receive a letter from the IRS called a CP 261 that says your S election was approved with an effective date of January 1, 2024. Because your handsome tax accountant is also smart, I would have told you before you decided to make the late S election that you would need to pay yourself a reasonable salary for the year. I file the 4th quarter employment tax return for your wages of $35,000 and you pay $6,447 in payroll taxes, $2,228 in federal income tax withholding, and $1,484 in Hawaii income tax withholding. A total of $10,159 in taxes that you would have paid via estimated taxes.
You do not need to cut yourself a check for the whole $35,000 plus tax. You can retroactively reclassify your distributions as wages. This is called after-the-fact payroll. Everything except paying the taxes is done on paper. Your savings are $6,120. I also recommend that you take your $6,120 in savings and contribute to a traditional IRA (Individual Retirement Account). Now you’ll save an additional $734 at a 12% marginal rate, and your $6,120 will grow tax free until your retirement. That’s exactly how the rich do it. My friend, you are now on your way to creating generational wealth.
