S corp tax benefits: a guide for small businesses

An S corp is a unique business structure that offers tax benefits to small business owners. By electing S corporation status, business income passes through directly to shareholders' personal tax returns, allowing owners to avoid double taxation.

S corp tax benefits make it an appealing choice if you are looking to minimize your self-employment tax and protect your personal assets.

How to elect S corp status

To take advantage of S corp tax benefits, you must first elect S corp status by filing Form 1120-S with the IRS. This notifies the IRS that your business will be treated as an S corporation for tax purposes.

Here’s how to elect S corp status:

1. Check eligibility: Your business entity must meet IRS requirements, including having no more than 100 shareholders and being a domestic corporation
2. File articles of incorporation: To legally form your business corporation, you must file articles of incorporation with the appropriate state authority
3. Submit form 1120-S: Complete and file Form 1120-S with the IRS to elect S corp status
4. Obtain shareholder approval: Shareholders must agree to the election of S corporation status

S corp tax benefits

A primary reason small business owners choose an S corp is the potential to save on taxes, especially by leveraging a tax provision that helps manage tax liabilities. Here’s how these tax benefits work:

1. Pass-through taxation

An S corp is considered a pass-through entity, meaning profits and losses pass directly to shareholders, simplifying the process of filing business tax documents. Unlike C corporations, which face double taxation—once at the corporate level and again when dividends are paid—S corps only tax the income at the individual tax rate of the shareholders. This avoids the double taxation that typically applies to C corps.

2. Self-employment tax savings

S corp owners can significantly reduce their self-employment tax liability through tax-saving strategies, such as claiming business tax deductions. While sole proprietors and LLCs must pay self-employment tax on all their income, S corp owners only pay self-employment taxes on their reasonable compensation or salary. The remaining income is taken as distributions but isn’t subject to self-employment tax.

Example: Imagine an S corp owner with $100,000 in business income. If they pay themselves a salary of $50,000, they’ll only pay self-employment tax on the salary portion. The remaining $50,000 in distributions isn’t taxed for self-employment tax purposes.

3. Tax-free distributions

In addition to self-employment tax savings, distributions from an S corp are generally tax-free at the corporate level. Shareholders only pay taxes on distributions as personal income tax, depending on their taxable income.

S corp vs. LLC vs. C corp

Choosing the right business structure is one of the important decisions that will determine your business’s success and tax efficiency. Each structure has its own advantages and disadvantages depending on your goals, size, and revenue:

Key differences in taxation

1. S corp vs. LLC

An LLC is a flexible business structure, typically used by small businesses, where owners, known as members, enjoy limited liability protection—meaning their personal assets are protected from business liabilities. It allows business income to be reported on owners' personal tax returns, which can be an advantage for those who want the pass-through taxation benefit.

However, the LLC structure doesn’t provide the same self-employment tax savings as an S corp. In an LLC, owners must pay self-employment taxes on the entire income of the business. This can be a disadvantage as it results in higher taxes compared to an S corp, where only the reasonable compensation—salary—is subject to self-employment taxes.

2. S corp vs. C corp

A C corporation is a separate legal entity that is taxed independently from its shareholders. Unlike an S corp, which benefits from pass-through taxation, a C corp is taxed on its corporate income at the corporate tax rate. Additionally, shareholders are taxed again when the corporation distributes profits as dividends, leading to double taxation.

While C corps face double taxation, they offer some advantages that S corps and LLCs don’t. C corporations can issue multiple classes of stock, which allows for greater flexibility in raising capital. This makes C corps a preferred structure for larger businesses and companies planning to go public.

However, the S corp offers tax-saving benefits that are more advantageous for small business owners, especially in terms of reducing self-employment taxes. Unlike a C corp, S corp owners only pay self-employment taxes on their salary, while distributions—profits paid to shareholders—aren’t subject to these taxes.

When is each structure the best option?

S corp

• Best for small businesses looking to minimize taxes on self-employment income
• Ideal for business owners who can pay themselves a reasonable salary and take additional profits as distributions
• Must meet certain criteria, such as having 100 or fewer shareholders and being a domestic corporation
• Great for small business owners who want the tax benefits of an LLC but prefer more control over tax management and payroll

LLC

• A good option for businesses that want a flexible structure and pass-through taxation without the administrative complexity of an S corp
• It’s a popular choice for freelancers, consultants, and sole proprietors who don’t want to deal with the strict filing requirements of an S corp
• However, LLC members do not benefit from the same self-employment tax savings as S corp owners

C corp

• Best for larger businesses or those planning to raise capital by offering stock or going public
• Provides unlimited growth potential through the ability to issue various classes of stock and attract venture capital
• However, the double taxation system makes it less favorable for small business owners who don’t plan to reinvest profits back into the business

Taxation of S corps

An S corp is a pass-through entity, meaning that income, deductions, and credits flow through to shareholders’ personal income tax returns. However, there are important considerations when it comes to self-employment taxes and distributions.

1. Self-employment taxes

S corp owners must pay self-employment taxes covering Social Security and Medicare on their reasonable compensation, or salary), but they don’t have to pay these taxes on distributions. This makes S corp tax status an attractive option for those aiming to minimize their self-employment tax liability.

2. Distributions and salaries

While S corp owners can take distributions from the business, it’s important to ensure the amount of salary paid is reasonable to avoid IRS scrutiny. The IRS requires that S corp owners be paid reasonable compensation for the work they perform, based on industry standards.

3. Payroll taxes

The salary paid to S corp owners is subject to payroll taxes. These taxes cover Social Security, Medicare, and other related obligations, just as they would for any employee. Distributions, however, are not.

Tax-saving tips for S corps

Here are some tax-saving strategies to help S corp owners reduce their tax liability:

• Contribute to retirement plans: S corp owners can take advantage of solo 401(k)s or SEP IRAs, which allow them to make larger contributions and reduce their taxable income
• Health insurance deduction: S corp owners can deduct the cost of their health insurance premiums for themselves and their families, which helps to lower overall tax liability
• Deduct business expenses: Ensure you’re deducting all business expenses, including business tax deductions, office supplies, and travel costs. These deductions help lower business income, reducing the overall taxable income.

S corp filing requirements

To maintain S corp status, you need to follow specific filing requirements every year:

• Form 1120-S: File this form annually to report the S corp's income, deductions, and distributions
• Schedule K-1: Each shareholder receives this form, which reports their share of income, deductions, and credits
• Payroll taxes: Report the salaries and wages paid to employees, including the S corp owner, on the appropriate payroll tax forms

Maximize your tax savings with Ramp’s accounting automation

Efficient financial management is key to maximizing the benefits of your S corp status. When you automate your accounting processes, you reduce manual work, eliminate errors, and ensure that your tax filings are always accurate and timely.

Accounting automation simplifies the entire process, from tracking business expenses to generating tax reports. With automatic categorization and real-time visibility into your financial data, you can focus more on growing your business and less on administrative tasks.

Ramp provides a comprehensive view of your business finances, making it easier to track expenses, predict future tax liabilities, and stay compliant with IRS requirements. Let Ramp handle the numbers, so you can make more informed financial decisions with confidence.

The information provided in this article does not constitute accounting, legal, or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.