If you’re a business owner, you’re probably used to hearing people talk about S Corporations. Put often the talk is confusing.
Fortunately, however, when you look at the S Corporation option from 40,000 feet, what you clearly see is that an S Corporation delivers three principal advantages for the small business owner:
Advantage #1: Limited Liability
People commonly misunderstand what an S Corporation even is. An S corporation is not a real corporation. At S Corporation is actually a set of tax accounting rules. But here’s the thing to understand: the S Corporation accounting rules are available as a practical matter only to traditional corporations and to limited liability companies.
In other words if you’re operating your business as an S Corporation, your business is either a traditional corporation or a limited liability company. What that entity status means is that when you choose to operate as an S corporation you automatically limit your liability because the first step you take to form an S Corporation–forming either a corporation or a limited liability company–means you get legal liability protection.
The upshot? The very first benefit or advantage of an S corporation is limited liability protection.
Advantage #2: Better Accounting
A second big benefit of the S Corporation option? Better accounting.
Here’s the deal. An S Corporation files a corporate tax return. That corporate tax return requires a good, solid profit loss statement, supplementary schedules of accounting information that reconcile many financial values, and in many cases a balance sheet as of the beginning of the year and as of the end of the year.
These additional accounting requirements that flow from the subchapter S reporting status mean that you will be required to maintain a better accounting system if you run your operation as an S corporation. You will not be able to use shoebox accounting, for example. You will need to use something like QuickBooks.
Accordingly, a second subtle but important benefit of an S Corporation is that an S Corporation essentially forces you to be more businesslike in your accounting.
Note: If you operate your business as a sole proprietorship or as a limited liability company treated as a sole proprietorship, you may be able to get away with very crude accounting. Sole proprietorships do not report balance sheet data as part of their tax return. In addition, sole proprietorships and LLCs taxed as sole proprietorships provide only a simple profit loss statement to the Internal Revenue Service.
Advantage #3: Potentially Gigantic Tax Savings
Tax savings represent the third big advantage of an S Corporation. And it’s important to note that an S Corporation actually delivers two forms of tax savings: corporate income tax savings and shareholder-employee payroll tax savings.
As compared to a traditional C corporation, for example, an S Corporation saves business income taxes. These savings stem from the fact that S corporations like partnerships and sole proprietorships do not themselves pay income taxes. Rather, the owners of the S Corporation pay the income taxes on the business profits.
Here’s the key thing to note, however, about paying an income tax on the S corporation’s business profits—that accounting is a way better outcome than the alternative which C corporations face.
A traditional corporation, also known as a C Corporation, also pays income taxes on its business profits. But then when those business profits are later distributed to shareholders, the shareholders pay another income tax.
A traditional C corporation, therefore, results in two income taxes on the business profit. One tax gets paid by the Corporation. The other tax gets paid by the shareholders.
Income taxes aren’t the only tax savings that an S corporation produces, however. An S Corporation also typically saves shareholder-employees payroll taxes (self-employment, Social Security and Medicare taxes). With sole proprietors, working partners in partnerships, working LLC members in limited liability companies, and shareholder-employees in traditional C corporations, the business owner pays payroll taxes on all of the profit he or she extracts as wages from the business.
With an S Corporation, in contrast, the shareholder employee only pays payroll taxes on that part of the extracted profit he or she specifically labels as “wages.” Commonly, shareholder employees of an S corporation save several thousand dollars each year by only labeling a portion of the extracted profit as “wages.” (The other part of the extracted profit is usually called a dividend by business owners but is in fact something else—a distribution.)
Note: Each shareholder employee enjoys the payroll savings. If an S Corporation has, for example, three shareholders, each shareholder may save several thousand dollars a year in payroll taxes.
Recommended Resources on S Corporations:
- LLC or Corporation?: How to Choose the Right Form for Your Business
- Surprisingly Simple: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- S-Corporation: Small Business Start-Up Kit
- How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners
- Setting Up a Limited Liability Company and S Corporation in California
- How to Convert a Sole Proprietorship to an LLC
- S Corporation Reasonable Compensation Tips
- LLCs and C Corporations: Similarities and Differences
- S Corporation Taxes for Employees and Shareholders