S-Corp Taxes for Dummies: The Easiest Guide You'll Find
As a small business owner, taxes are probably one of the last things you want to think about. They're overwhelming. And confusing. You don't understand them very much, but you keep hearing that you could save a lot on taxes if you register as an S Corporation. So here you are, searching for an S-Corp Taxes for Dummies Guide.
Luckily, you've found just what you were looking for! In this article, we'll help you understand how S-Corporation taxes work in a friendly and straightforward way. By the end, you'll have a clear grasp of how you pay taxes as an S-Corporation and the benefits of doing so. Grab your favorite beverage, and let's dive in!
S-Corp Taxes for Dummies, Explained
Here are a few things about S Corporations and taxes that you should be aware of. We'll discuss all of them in more detail later in the article, but this is a helpful place to start!
S-Corp Is a Tax Designation, Not a Business Entity: An S-Corporation is a tax status that can be elected by eligible businesses. It is NOT a business structure like an LLC (limited liability company) or a C Corporation (C-Corp).
Pass-Through Taxation: Income, losses, deductions, and credits pass through the business to the shareholders (the owners, AKA you), who report them on their personal tax returns.
Potential Tax Savings: S-Corporation status can help you save on self-employment taxes and avoid double taxation. This is one of the main reasons why many business owners choose the S Corporation tax status.
These key takeaways may not entirely make sense to you right now, but that's okay! They'll become more clear later in the article 😊
What Is an S-Corp?
An S-Corp is a special tax designation that a business can elect to have with the IRS. Unlike a C-Corporation, which pays taxes on its income and then shareholders (owners) also pay taxes on dividends (double taxation), an S-Corp's income is taxed only at the shareholder level. This is known as pass-through taxation. The IRS estimates that there are over 5 million S Corporations in the US.
Key Things to Know About S-Corporations
Limited Liability
The personal assets of the S-Corporation shareholders, such as their home and personal bank accounts, are shielded from the debts and liabilities of the business. This means that if your business has debt or faces legal action, your personal property and finances are safe, as long as you maintain a clear separation between personal and business finances!
Eligibility Requirements
Not all businesses can elect the S Corporation status. Certain types of companies, such as domestic international sales corporations and insurance companies, can't become S Corporations.
According to the IRS, these are the requirements to become an S-Corporation:
Be a domestic corporation
Individuals, certain trusts, and estates can be shareholders
Partnerships and non-resident aliens (people who are not U.S. citizens or residents) can't be shareholders
You can have no more than 100 shareholders
You can only have one class of stock
Certain financial institutions, insurance companies, and domestic international sales corporations are not eligible
That said, most small business owners are typically eligible for the S-Corporation tax status!
Tax Benefits of an S-Corp
One of the main reasons why business owners elect the S-Corporation status is because of the tax advantages that it offers.
Avoid Double Taxation
In a traditional C-Corporation, the company's profits are taxed at the corporate level first. This is known as the corporate income tax. When these after-tax profits are distributed to shareholders (the owners) as dividends, the shareholders must then pay personal income tax on these dividends. This means that you're effectively being taxed twice on the same business income! For many business owners, this is a significant tax burden.
In contrast, an S-Corp is not taxed at the corporate level. Your profits and losses pass directly to you, the shareholder, and you report them on your personal income tax report. This pass-through taxation means that the income is only taxed once at the individual level and there's no corporate income tax. As a result, a bigger portion of your business income actually ends up in your pocket!
Self-Employment Tax Savings
As a business owner, you have to pay self-employment taxes. If you run an LLC, self-employment taxes (which include Social Security and Medicare) amount to 15.3% of your net earnings and are typically applied to all profits. In contrast, S-Corp owners can split their income into a salary and a distribution. The salary will still be subject to self-employment taxes, but the distributions will not be!
Here's an example. An S-Corp owner earns $100,000. They take a $60,000 salary and $40,000 in distributions. The self-employment tax on the $60,000 salary would be $9,180 (15.3% of $60,000). The $40,000 distribution is not taxable income for self-employment taxes, which saves the owner from paying $6,120 (15.3% of $40,000)! Self-employment tax savings are one of the biggest pros of S-Corporations.
S-Corp Taxes for Dummies
Federal Taxes
An S-Corp itself does not pay federal income tax. Instead, it files an informational return, Form 1120S, which reports the company's income, deductions, and credits. The S-Corp also issues a Schedule K-1 to each shareholder, detailing their share of the income, deductions, and credits, which they report on their personal income tax return when they pay income tax.
State Taxes
State tax obligations for S-Corps depend on your state. Some states recognize S-Corps and mirror federal tax treatment, while others do not. You may need to pay state income taxes, franchise taxes, and annual fees.
We are happy to help you navigate your S-Corporation taxation obligations. Learn more about our tax services!
S-Corporations and Self-Employment Taxes
Federal and state taxes aside, S-Corporation owners can also save on self-employment taxes. But how exactly does this work? Here's everything you need to know!
Reasonable Salary Requirement
S-Corp shareholders who are also employees must receive a reasonable salary for their work. This salary is subject to employment taxes, including Social Security and Medicare taxes. The IRS mandates that shareholder-employees receive a salary that reflects the value of the services they provide to the corporation.
In other words, your salary can't be $1. It has to make sense in the overall context of how much your business makes!
Distributions vs. Salaries
Beyond the reasonable salary, additional profits can be distributed to shareholders as dividends. These distributions are not subject to self-employment taxes, which helps you save on taxes.
Working with a tax professional can help you figure out how to lower your tax burden. For example, we recently helped a realtor save $9,811 in tax!
Compliance and Risks
The S-Corp tax status offers tax advantages, but it’s important to comply with IRS regulations to avoid penalties. The IRS closely monitors S-Corp compensation to ensure that you're paying yourself a reasonable salary. Underpaying salaries and taking larger distributions can trigger audits and result in penalties.
Make sure to document your reasoning for salary decisions and use industry standards and comparable positions to justify the amounts you're paying yourself for tax purposes!
FAQs
How Much Tax Will I Pay on S-Corp?
There is, unfortunately, no easy answer to this question! It depends on several factors, including your share of the corporation's income and your personal tax rate. S-Corporations are pass-through entities, which means that they are not taxed at the corporate level like C-Corporations. Instead, shareholders pay tax through their personal tax returns. Your reasonable salary is also subject to the 15.3% employment taxes (Social Security and Medicare). Learn more about what percentage a small business pays in taxes.
What's a Reasonable Salary for S-Corp?
A reasonable salary is a salary that is comparable to what would be paid to someone with similar duties in a similar business. The IRS looks at various things to determine if your salary is reasonable, including your duties and responsibilities, the complexity and size of your business, and how much other businesses in your industry pay for a similar position.
For example, imagine you run a copywriting agency. You can compare your managerial and writing responsibilities to those of senior copywriters in similar agencies and find out that they are paid, on average, $80,000 annually. This means that a reasonable salary for yourself should be around that benchmark.
Are You Double-Taxed as an S-Corp?
No, S-Corps avoid double taxation. In a C-Corporation, income is taxed at both the corporate level and again at the shareholder level when dividends are distributed. With an S-Corp, shareholders report their income on their personal tax returns. This means that the income is only taxed once!
Is LLC or S-Corp Better for Taxes?
There's no one-size-fits-all answer to this question. Both S-Corporations and limited liability companies offer pass-through taxation, but there are key differences. An LLC offers more flexibility in management but is subject to self-employment taxes on all net earnings. An S-Corp allows you to save money on self-employment taxes because only your salary is taxed. Learn more about the differences between LLC vs. S-Corp!
What Can You Write Off on Taxes for S-Corp?
There are SO many deductible business expenses to reduce your taxable income, and many business owners don't fully take advantage of them! Office expenses, travel, marketing, and continuing education are just some examples of business deductions you can take advantage of as an S-Corp.
Navigating S-Corp Taxes Is Easier with Desi Tax
At Desi Tax Services®, we help business owners confidently navigate tax season, owe less to the government, and stop feeling like you don't understand your numbers! We focus on building relationships instead of simply filing paperwork and create a customized plan that makes sense for your business.
Contact Desi Tax Services® today for a free consultation! We are here to help you find clarity and start saving money you didn't know you had.
