Overview of S Corporation Taxation
An S corporation (S Corp) is a corporation that has filed to be taxed as an S corporation with the IRS. S corps are pass-through entities, meaning the S corp itself is not taxed on its profits. Instead, the shareholders are taxed on their share of the S corp’s profits.
The main difference between an S corp and C corp is taxation. A C corp pays taxes on its profits, then shareholders pay taxes again on dividends. An S corp avoids double taxation by passing profits directly to shareholders.
Tax Implications for S Corp Owners
The owners of the S Corp will be taxed based on their percentage of ownership in shares. For example, if the S Corp has profits of $500,000 and there are 4 shareholders, then each shareholder will pay taxes on $100,000 in profits.
Shareholders do not pay self-employment tax on their share of an S-corp’s profits. However, S corp owners that work as employees for the S-corp will need to receive a “reasonable” salary before there can be any profit distributions.
Compensation Structure for S Corp Owners
Shareholders pay taxes on two types of income – wage income and profit distributions. The wage income is subject to payroll tax. Any shareholder/employee of the S Corp must be paid a reasonable salary, which is determined by considering several factors. The profit distribution is not taxed. This means that the dividends are paid out tax-free.
To elect S corp status, a business must file Form 2553 with the IRS, signed by all shareholders. The business must meet requirements like having only eligible shareholders and being a domestic corporation.
In summary, S corps provide tax savings to owners by avoiding double taxation. Owners must pay themselves a reasonable salary subject to payroll taxes. Additional profits are passed to owners as distributions, which avoid payroll taxes. This enables owners to save significantly on taxes.