An S corporation is a type of corporation that elects to pass its corporate income and losses directly to its shareholders for federal tax purposes. This allows S corps to avoid double taxation on the corporate income. S corp owners are treated as employees and can reduce their tax burden by not having to pay self-employment taxes on company profits that pass directly through to their personal tax returns. However, they must pay themselves reasonable salaries subject to payroll taxes.
While S corps do not have to pay tax on corporate profits, owners must still pay individual income tax on their share of those profits. An advantage of the S corp structure is the ability for owners to take distributions up to the amount of profits that bypassed payroll taxes, thus reducing their overall tax burden compared to merely taking a salary.
S corp owners pay regular income tax on their distribution, but they are not considered to be self-employed, so they pay no self-employment tax on this distribution. If any of the owners also are employees, they receive a salary, from which FICA taxes (Social Security and Medicare tax) are withheld. The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes. Those profits are only subject to income tax.
S corp owners will have to pay self-employment taxes on their wages, though. For instance, if an S corp owner pays themselves a $70,000 salary, they will pay FICA on that amount only.
The main benefit of incorporating as an S Corporation over being self-employed is the tax savings on self-employment taxes (Social Security and Medicare). By electing S corp and being treated as an employee, the business owner pays their portion of FICA on ONLY their reasonable salary.
Business owners should carefully weigh the pros and cons with an accountant to determine if electing S corp status makes sense for their situation. Key considerations include the level of profitability, number of shareholders, and if the primary owners work in the business.
Some disadvantages of the S corp structure include more complex tax and recordkeeping requirements, and restrictions on ownership structures compared to LLCs.
Overall, the S corp structure can provide tax savings for profitable small businesses with active owners.