CPA Explains: What Is an S Corporation? (Special Edition)
If you’ve spent any time researching small business taxes, you’ve probably seen or heard about the tax-saving capabilities of S Corporations.
While an S Corporation can provide tax advantages for the right business, it is not a magical tax-saving strategy that works for everyone.
In fact, an S Corporation isn’t even technically a type of business entity in the same way an LLC or corporation is. S Corporation status is a federal tax election that an eligible business can make. An LLC, for example, may be able to elect to be taxed as an S Corporation if it meets the IRS requirements.
Let’s break down the basics.
What Is an S Corporation?
An S Corporation is a business that has elected to be taxed under Subchapter S of the Internal Revenue Code.
The biggest feature of an S Corporation is that it is a pass-through entity. The business’s income, losses, deductions, and credits pass through to the shareholders, who report their share on their individual tax returns. This avoids the traditional corporate-level double taxation associated with C Corporations.
An S Corporation typically files:
- Form 1120-S — the S Corporation tax return
- Schedule K-1 — provided to shareholders showing their share of business income and other tax items
The business itself is still responsible for maintaining records (board minutes, income/expense, etc.), filing returns (payroll, sales tax, income tax, etc.), and following the applicable rules. The S Corporation election does not make taxes disappear—it simply changes how the business and its owners are taxed.
The Potential Self-Employment Tax Savings
This is probably the primary reason many small business owners consider an S Corporation.
Let’s use a simplified example.
Imagine your business generates $150,000 of profit before paying you as the owner.
If you operate as a sole proprietor, you’ll owe 15.3% self-employment tax on the $150,000 of profit.
With an S Corporation, an owner who actively works in the business may generally receive compensation in two different ways:
- W-2 wages for the work they perform
- Shareholder distributions from the business
Wages are subject to payroll taxes. However, S Corporation pass-through income isn’t treated as self-employment income, which creates the potential for tax savings.
This is where many people stop learning about S Corporations; however, unfortunately, there is an important catch.
You Can’t Just Pay Yourself $10,000 and Take the Rest as Distributions
One of the biggest misconceptions about S Corporations is that the owner can simply pay themselves a very small salary and take the rest of the company’s income as distributions.
The IRS requires shareholder-employees who perform services for the business to receive reasonable compensation before taking non-wage distributions. The IRS can reclassify distributions as wages if it determines that the owner was not paid appropriately for the work they performed.
Reasonable compensation is not determined by picking a random percentage of business income.
The IRS considers factors such as:
- Your training and experience
- Your duties and responsibilities
- The time you spend working in the business
- What similar businesses pay for similar work
- The company’s use of employees, equipment, and capital
For example, if you are a consultant generating $200,000 of revenue primarily because of your personal work, paying yourself a $30,000 salary and taking the rest as distributions could be difficult to justify.
On the other hand, a business where profits are generated substantially through employees, equipment, systems, or other capital may present a different reasonable compensation analysis.
The potential tax savings are real once you determine how to compensate yourself properly.
Who Can Own an S Corporation?
S Corporations have ownership restrictions that make them less flexible than some other business structures.
Generally, an S Corporation must:
- Be a domestic corporation or eligible domestic entity
- Have no more than 100 shareholders
- Have eligible shareholders, generally individuals and certain trusts or estates (no partnerships)
- Not have nonresident alien shareholders
- Have only one class of stock
- Avoid certain types of ineligible businesses
S Corporations can have differences in voting rights, but they generally cannot create different economic rights that give certain shareholders preferential rights to distributions or liquidation proceeds. In simple terms, the ownership structure needs to be relatively straightforward.
What About Distributions?
Because an S Corporation generally has one class of stock, distributions should generally follow ownership percentages.
For example, if you own 60% of the company and another shareholder owns 40%, the economic rights attached to the ownership interests generally need to reflect that ownership structure. So distributions need to be split 60/40.
This can become more complicated than it initially sounds, which is one reason S Corporations may not be ideal for every multi-owner business.
S Corporations Come With More Administration
The potential tax savings are not free.
Operating as an S Corporation generally means additional responsibilities, including:
- Running payroll for shareholder-employees
- Filing payroll tax returns
- Filing Form 1120-S
- Preparing Schedule K-1s
- Maintaining corporate or entity records
- Tracking shareholder basis
- Monitoring distributions and ownership changes
Shareholder basis is particularly important because it can affect whether losses are deductible and whether distributions are taxable.
There are also additional costs associated with payroll providers, tax preparation, bookkeeping, and professional advice.
For a business generating a relatively small amount of profit, those additional costs and administrative requirements may outweigh the potential tax savings.
Is an S Corporation Right for You?
An S Corporation may be worth considering when:
- Your business consistently generates meaningful profits
- You actively work in the business
- There is enough income to pay reasonable compensation and still have remaining profit
- The potential payroll tax savings outweigh the additional administrative costs
- Your ownership structure meets the S Corporation requirements
On the other hand, an S Corporation may be less attractive if the business:
- Has inconsistent or minimal profits
- Needs multiple classes of ownership
- Plans to bring in investors who may not qualify as S Corporation shareholders
- Does not generate enough profit to justify the additional compliance costs
There is no universal income level where someone should automatically become an S Corporation.
The answer depends on your business profitability, reasonable compensation, ownership structure, future plans, and overall tax situation.
My Two Cents
S Corporations can be incredibly valuable for the right business owner—but I think they’re often oversold as a simple way to “avoid self-employment tax.”
That’s not really how they work.
The real question isn’t: “Can I elect S Corporation status?”
It’s: “Will the potential tax savings exceed the additional costs, complexity, and administrative requirements for my specific business?”
For some business owners, the answer is absolutely yes. For others, remaining a sole proprietor or partnership may make more sense.
Before making the election, it is worth running the numbers and considering the entire picture—not just the potential self-employment tax savings.
– Brendan Tiedeman, CPA, CVA
Disclaimer
This article is for educational and informational purposes only and should not be considered tax, legal, investment, or financial advice. Tax laws and individual circumstances vary, and readers should consult with a qualified tax or legal professional regarding their specific business structure and tax situation.
