An S Corporation Could Reduce Your Business Tax Liability

Learn How This Special Tax Designation Could Provide Significant Savings

Did you know that two of the most common forms of small business legal setups are LLCs and sole proprietorships? It’s not hard to see why LLCs are popular, as they provide you with a degree of asset protection while also being allowed to establish a business checking account and line of credit for your business. However, though these benefits are great, LLCs on their own provide no tax benefits. This may be why S Corporations account for 33% of small businesses per a 2018 report from the National Small Business Association.

Could this be the right strategic move for your small business? Read on to learn how registering as an S Corp could help you maximize your earnings and mitigate your tax burden.

What is an S Corporation?

Let’s start with the basics. In short, an S Corporation (S Corp), is a tax election. It’s a special designation carved out of the U.S. tax code specifically for small businesses. By making your business an S Corp, you’re essentially signifying that the business is a separate entity from the owner. Upon choosing to be taxed as an S Corp, any profits or losses the company makes will be passed through to the shareholders through a K-1 Federal Tax Form.  The other change that takes place when electing to be taxed as an S Corp is that you are permitted to receive a salary from your business (W-2 Income). Both of these things, the salary you draw, and all Pass-Through Income are taxed differently which is where you’ll end up saving money.

Who Can Own an S Corporation?

Unfortunately, not just any business owner can elect to change their business to an S Corporation. The IRS has strict rules in place as to who can have an S Corporation. You can see a full list of requirements in the IRS’ instructions for Form 2553, which you’ll need when filing as an S Corp. The main requirements are as follows:

  • You must have 100 or fewer shareholders
  • You can only issue one class of stock
  • You cannot have any entities as investors
  • None of your shareholders can be considered a “nonresident alien.” It’s important to note that you can have a shareholder who isn’t a permanent resident or U.S. Citizen if they’re considered a resident alien. That is if they’ve been in the U.S. for at least 31 days in the current year and 183 days over the last three years. You can find more details on how the IRS categorizes these two distinctions by using the “substantial presence” test.

Benefits of an S Corp

An S Corp can be a powerful way to mitigate your tax burden and save you money. Here’s how it works:

Limited Liability

By making your business a separate entity from yourself, you’ll be able to enjoy limited liability. This means the company itself will be held legally liable for any financial obligations and debts, rather than those who own the company. So, any personal assets of yours – things like homes, cars and investment accounts – will be protected should creditors seek to collect from the business.

Pass-Through Status

Once you choose to structure your business as an S Corp, your business itself stops being taxed. Instead, you’ll only pay taxes on whatever is earned from your business, which will be recorded as personal income and is taxed at your personal income tax rate. Whether you’re operating at a loss or making money, you’ll benefit from this change because you’ll be able to write off any losses on your personal tax returns, or if your business is doing well, it just adds to your personal return.

Lower Social Security and Medicare Taxes

As a business owner, you’re personally responsible for paying Social Security and Medicare taxes on all net earnings from the business. As an owner of an S Corporation, however, you’re recognized as an employee and the S Corp itself is your employer, meaning you’ll only pay taxes based on your compensation. So, you’ll each pay half of the Social Security and Medicare taxes that are due on your wages and then your business will be able to deduct your salary and its portion of payroll taxes.

Drawbacks of an S Corporation

As with any business decision, it’s important to weigh the advantages and disadvantaged. Before you make the move to register as an S Corp, here are a few things you should be aware of:

Reduced Benefits

One of the consequences of reducing your contributions to Social Security is that you may reduce your future benefits, too. You’ll want to speak with a professional to determine what reduced Social Security benefits would look like and how it may impact your larger financial plan.

Increased Payroll and Reporting Costs

Since you’ll be paying yourself with a formal W-2 salary when you own an S Corporation, you’ll be required to report and track this. This means you’ll likely have to purchase payroll software, which can be expensive. Additionally, you may need to cover any additional costs for the tax forms you’ll need in order to file your taxes as an S Corp.

Audit Risk

When seeing the benefits that come from how an S Corp is taxed, you may be tempted to take out as small of a salary as possible so that you can minimize the amount you pay towards self-employment tax. However, the IRS mandates that the salary you draw be “reasonable.” This means you must pay yourself a salary that is on par with others in your industry. You’ll also want to be aware of how other tax deductions and regulations come into play depending on the salary you draw from the S Corp.

Restrictions on Shareholders

If you’re looking to grow your business, then electing to register as an S Corporation may not be the right choice for you. As an S Corp, you won’t be permitted to seek out a venture capitalist or other entity for support and you’re limited to no more than 100 shareholders. This could lead you to having to funnel some of your company’s profit back into itself if you’re looking to raise more money for your business. This could lead to you being hit with a significant tax bill on your personal return, and you won’t be able to depend on the proceeds from your business to cover that bill.

Switching Your Business to an S Corp

Deciding to switch your business over to an S Corporation is a big move and there are many nuances and aspects to switching that aren’t included in this article. So, you’ll want to be sure you’ve done your research and appropriately weighed all the benefits and drawbacks before determining that this is the right choice for your company. It may be wise to sit down with a professional financial advisor who can review your business structure, look at all cash flows and tax elections and educate you on ways that you can make the most of your situation. In doing so, you’ll be able to have peace of mind knowing that you’re making the best decision for your business, whether that means registering as an S Corp or otherwise.

At Paces Ferry Wealth, we understand how hard you’re working to build, maintain, and grow your small business. Our team of financial advisors is ready to help you choose a strategy that positions you for long-term financial success. If you’d like to begin a conversation with one of our advisors about whether switching your business to an S Corp is the right move for you, please reach out to schedule a meeting with us today.


Zachary Morris

Zachary Morris, CFP®

Having traveled to over 35 countries, Zach is a believer in Ralph Waldo Emerson’s statement that Life is about the journey, not the destination. Being a CERTIFIED FINANCIAL PLANNER™ provides Zach the opportunity to help clients define and realize their journey, and co-founding Paces Ferry Wealth Advisors, an independent firm, allows the freedom to define the client experience along the way.