S corp tax benefits: a guide for small businesses

Incorporating your small business as an S Corp is one of the best ways to save on self-employment taxes. An S Corp’s tax benefits are numerous and essential for businesses and business owners.  

By incorporating your business as an S Corp, you can avoid double taxation, which helps you save money, manage your profits and invest more in your business.  

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This guide will walk you through the advantages and disadvantages of structuring your business as an S Corp, along with the following:  

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What is an S Corp?  

An S Corporation, also known as an S Corp, is a type of business structure small businesses can opt for if they wish to pass company income directly to shareholders without incurring corporate taxes. S Corps must fulfill certain criteria to qualify for this tax treatment.  

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This business structure is similar to a C Corp but differs slightly. A C Corp is a business that pays corporate income tax and can have unlimited stockholders. Both legal entities protect personal assets and allow you to claim small business tax deductions.  

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However, C Corp owners face “double taxation,” but this can be avoided by electing an S Corp treatment with the IRS (Internal Revenue Services).  

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An S Corp is a for-profit company governed by state corporation laws. This business structure offers liability protection, ownership, and management advantages, just like a C Corp.  

Additionally, it must adhere to internal procedures and formalities, such as having a board of directors, creating corporate bylaws, holding shareholders' meetings, and maintaining minutes of critical corporate meetings.

For S Corps, the maximum number of significant shareholders or owners is 100, and each owner must be a US citizen or lawful permanent resident. Also, businesses registered as LLCs can elect S Corp taxation.

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IRS definition of an S Corp  

When considering structuring your business as an S Corp, you must determine if your corporation meets the IRS standard. According to the IRS, S Corps are entities with one class of stock domestically formed inside the United States, with no more than 100 shareholders.  

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Additionally, the IRS mandates that all shareholders be eligible, implying they must be either natural persons, certain trusts and estates, or specified tax-exempt organizations. Also, corporations, partnerships, and non-resident aliens are not eligible shareholders for an S Corp.

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Now that we’re clear on what an S Corp is and the IRS requirements of an S Corp, let’s go over how you can structure your business as one.  

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How to set up your company as an S Corp  

Here are the steps you must take to set up an S Corp:

1. Incorporate your business.  

Your business must be established as a corporation first. To do this, you must fill out and submit the necessary paperwork through a registered agent or directly with the Secretary of the state you’re incorporating in and pay the required filing fee.  

2. File task form  

Once the incorporation procedure is finished, IRS Form 2553 (Election by a Small Business Corporation) must be signed by all shareholders and submitted to the IRS to receive the S Corp designation.

3. Issue stock  

The number of shares to be issued, which may be distributed as paper or electronic certificates, must be approved by your board. Once done, the shareholders of the corporation can file their tax returns upon receiving any distributions.

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Note that you can incorporate an LLC and elect S Corp taxation status. To do this, you must follow the same steps as above but incorporate as an LLC and indicate you wish to be taxed as an S Corp.  

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How do S Corps pay taxes?  

S Corps function as a pass-through entity. This means instead of paying small business taxes at the corporate level; taxes are deducted from the salary paid to shareholders at the individual level.  

An S Corp’s gross income or total profit isn't seen as a corporate distribution. The company's shareholders are the corporation's employees, including the business owner. These shareholders are paid "a reasonable salary."  

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For instance, if a company earns a profit of $500,000 at the end of the year, it will pay taxes on that amount (after accounting for all business expense categories.) Any money transferred to shareholders is liable for taxation as well.  

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For S Corps, the profits of $500,000 are passed directly to shareholders, who pay individual taxes. Thus, eliminating the corporate tax component saves shareholders significant amounts of money.  

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Differences between S Corps and C Corps  

Here are the differences between S Corps and C Corps:  

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S Corps versus LLCs  

Here are the differences between S Corps and LLCs.  

Number of members  

According to the IRS, S Corps can have up to 100 shareholders or fewer. An LLC can have an unlimited number of members.  

Ownership

LLCs can be owned by any type of corporate entity or individuals. Corporations, partnerships, and non-resident aliens are not eligible shareholders for S Corps.  

Management structure  

S Corps must have a board of directors and officers to oversee corporate decisions. LLCs can choose whether the owners or designated managers will run the business.  

Business operations  

S Corps must adhere to internal formalities and strict regulations regarding adopting corporate bylaws, conducting shareholders meetings, and issuing stock. Business operations are much simpler for LLCs because they're not legally required to follow these complex rules. In addition, expense management for small businesses incorporated as S Corps also becomes more complex.

Allocation of profits and losses  

Shareholders of S corps receive their earnings and losses in proportion to their ownership stakes. LLCs have almost unlimited flexibility in how they distribute profits and losses.

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What are the tax benefits of an S Corp?  

Let’s look at the tax benefits of an S Corp in more detail:  

Pass-through taxation

Pass-through taxation is the most significant tax advantage. A S Corp does not pay federal taxes. Instead, the earnings are distributed to the business's owners, who pay personal income taxes on their portion of the company.

Savings on self-employment taxes  

For a self-employed person operating as a sole proprietor, a 15.3 percent tax is charged on earned income. S-Corps are not subject to self-employment taxes. As a business owner of an S Corp, you’re only taxed as an employee, not on the corporate level.  

Here’s an example:

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Let’s say your business generates $200,000 in profits, and you pay yourself a reasonable salary of $80,000. This leaves (200,000 – 80,000) $120,000 as residual profit.  

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If you’ve incorporated as a sole proprietor or an LLC, you will owe the following taxes:  

Income tax on your salary of $80,000  

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Self-employment tax of (15.3 percent of $120,000) $18,360.  

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By incorporating as an S Corp, you’ll save self-employment taxes of $18,360 or 9.1 percent of your profits in this case.  

Tax savings on health insurance premiums

S Corp owners can save significant amounts of money on their health insurance premiums. This is a bit tricky, but a good tax advisor will help you figure this out. Here’s how it briefly works:  

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You can pay health insurance premiums as a part of your reasonable salary. The premium is exempt from self-employment taxes and is deductible on your income tax filing.  

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For instance, from our previous example, you paid yourself $80,000 as a reasonable salary. Let’s assume you included $10,000 as health insurance premiums in that amount.  

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The money now eligible for Social Security and Medicare taxes is (80,000 – 10,000) $70,000. You’ll also avoid payroll taxes (15.3 percent) on health insurance premiums, saving you (15.3 percent of $10,000) $1,530.  

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Disadvantages of an S Corp  

There are certain drawbacks to structuring your business as an S Corp, and they include the following:  

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S corps are subject to more rules and regulations that could increase operational burden compared to an LLC

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The restrictions on the type and number of shareholders may be burdensome for a corporation expanding quickly and seeking venture financing or institutional investors.  

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An S Corp may have voting and non-voting shares but only one class of stock. As a result, you cannot issue varying rights to dividends and distributions.

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How Ramp helps all types of businesses  

Every business needs help managing its expenses in real time and maximizing its tax deductions:

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Here’s how Ramp helps businesses of every size and legal type, including S Corps, save money and time.  

Automated expense management  

Most businesses spend multiple weeks closing books, but Ramp helps you close your books within a day. Save hours of work every month with a startup finance expense automation process so easy to use that everyone can understand.  

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Ramp automatically categorizes expenses, syncing data in real-time, helping you close your books up to 10x faster.

AI-powered receipt matching  

Ramp’s AI-powered receipt matching helps verify receipts against the right transaction. You can end mindless busy work with a tool that constantly confirms receipts against the correct transaction.  

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Use Ramp’s integration with Gmail, Lyft, and numerous other apps to gather your receipts for zero-touch expense management.  

Seamless accounting integration  

With Ramp, you can connect to your apps and automate your financial processes with pre-built software connections for well-known accounting, teamwork, and security solutions.  

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You can also automate your accounting with best-in-class integrations for QuickBooks, Xero, Sage, and NetSuite to close your books faster.

Uncover savings  

Ramp’s savings insights provide useful suggestions that’ll help you reduce marketing spend sent regularly. You can save millions of dollars annually by leveraging the insights and pricing intelligence sent to you.

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Incorporating your business as an S Corp is the best way to save on federal taxes. However, there are limitations you'll encounter. You won’t completely control the business as an S Corp business owner and will face IRS-mandated restrictions.  

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Check whether an S Corp is the right choice for you before choosing to go down this route.

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