A few months ago, we wrote a blog post about how small business owners may prepare for the S Corporation annual tax return deadline.
This same post shares insight into the S Corporation entity. An S Corporation is a corporation that elects to pass corporate income, losses, deductions, and credits to its shareholders for federal tax purposes.
While we did provide information about paperwork necessary to file an S Corp’s annual tax return, we didn’t get the chance to dive deeper into why an entrepreneur would incorporate as an S Corporation. Let’s take a look at some of the tax benefits, and overall small business benefits, entrepreneurs receive when they incorporate as this entity.
Our original article notes that business income in an S Corporation may “pass-through” to the individual owners of the S Corporation.
An S Corporation is a pass-through entity for federal and state income tax purposes. By passing the business income through to the owners, the company is not taxed at the corporate rate. (Giving an S Corp the bonus benefit of no corporate income tax!) The shareholders will claim the income and losses from the business on their personal tax returns. This allows the owners of the business to legally avoid double taxation.
Similarly, an LLC is also a pass-through entity. However, it is classified as a partnership for income tax purposes. An LLC may elect to be taxed as an S Corporation, allowing the entity to avoid double taxation.
Self-Employment Tax Savings
Let’s say that you are incorporated as a sole proprietor. A sole proprietor is often considered a default entity formation. It is one of the easiest to file paperwork for and allows the owner to be held fully responsible for the business.
However, sole proprietors often face added responsibilities with their self-employment tax payments. This tax covers Social Security and Medicare obligations because the business is not taxed as a separate entity. If you are an employee with a company, for example, this expense is typically matched by employer. Sole proprietors are responsible for paying the entire amount of self-employment tax — which can add up to thousands of dollars in taxes!
Luckily, electing an S Corporation can help lower tax bills. Owners of an S Corp are treated as employees. This means they may draw a reasonable salary from the profits of the business. Only these wages are subject to self-employment taxes. Remaining profits are distributed to the owner as dividends. These dividends are taxed at a lower rate than income, allowing for an even further reduction in your tax liability.
S Corporations provide their owners with limited liability protection. This allows owners to create a separation between their personal and professional assets. Limited liability protection protects the assets of its shareholders in the event of unforeseen circumstances, such as seizure of collateral by creditors to pay back a business debt.
Ready to Form an S Corporation?
S Corporations are generally a popular incorporation choice for small businesses or freelancers that earn between $80,000 to $100,000 (or more) each year. Investors also highly recommend businesses that are incorporated as S Corporations and S Corps may improve your chances of getting approved for small business loans.
However, it’s important that prior to electing an S Corporation filing, or changing your existing entity formation, you speak with a trusted CPA. Do not make the decision on your own. A trusted financial advisor will be able to answer any further questions you have about the entity and share additional benefits that come with the formation with you.
Deborah Sweeney is the CEO of MyCorporation.com. MyCorporation is a leader in online legal filing services for entrepreneurs and businesses, providing start-up bundles that include corporation and LLC formation, registered agent, DBA, and trademark & copyright filing services. MyCorporation does all the work, making the business formation and maintenance quick and painless, so business owners can focus on what they do best. Follow her on Twitter @deborahsweeney and @mycorporation.
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