The Tax Benefits of an S Corporation
With the Tax Cuts and Jobs Act creating a pass-through tax deduction, it might be a good option to select S Corporation status for your LLC.
What is an S Corporation?
According to the IRS (Inland Revenue Services), an S Corp is a tax classification that allows businesses to pass tax from income, losses, and deductibles on to its shareholders through personal income tax.
This means that taxes are not paid at the corporate level, similar to partnerships, and the business is therefore exempt from double taxation.
An S Corp can be formed by incorporating a regular corporation or by filing to become an LLC (Limited Liability Company) and then electing S Corp status with the IRS.
How Do Taxes Work?
In order to file for taxes, an S Corp must submit Form 1120S U.S Income Tax Return for an S Corporation. The business reports its income, deductions, profits, losses, and tax credits for the financial year.
Before filling out the form, the following information is required:
- Date of incorporation and S Corporation status date.
- EIN (Employer Identification Number) as well as the business activity code.
- A balance sheet and a profit and loss statement for the business.
- Proof of payments to any independent contractors. It must total at least $600 for the year and Form 1099, Information Filing, should have been sent.
S Corp owners must also provide shareholders with a Schedule K-1 listing their respective shares of the items on the corporation’s Form 1120S.
The shareholders must then file Schedule E with their personal tax returns (Form 1040) showing their share of corporate income or losses.
What are the Tax Benefits?
1. No double taxation
As stated previously, an S Corporation passes through taxation to its shareholders. This is reflected on their private income statements and taxed through personal income tax. An S Corp does not pay taxes at a corporate level.
2. Self-employment tax saving
The reason S Corp status is so attractive for small business owners is because unlike partnerships, sole proprietorships, LLCs, and traditional corporations, S Corp shareholders are not subject to self-employment tax.
Business owners only pay taxes on their wages and not on their share of the business’s profits. Other income is paid as “distributions” to shareholders which are not subject to self-employment tax. This method of taxation can save a small business on tax costs.
There are, however, rules in place to avoid shareholders earning a $0 salary and avoiding self-employment tax entirely. A shareholder employed by the business must consistently earn a reasonable salary. A reasonable salary will be market-related and can be researched by looking at job sites or through the U.S Bureau of Labor Statistics.
3. Health Insurance Tax Saving
As with other business structures, an S Corp can offer its employees health insurance. When the premium is covered by the S Corp, the employees are not taxed on it and the business can claim a tax deduction for the premiums contributed.
How to Calculate the Tax Saving
For non-tax experts, it can be challenging to calculate whether electing S Corp status is the best choice for their prospective business. Fortunately, this S Corp tax calculator can help. The tax calculator will compare the tax costs of a traditional LLC to those of an S Corp, making the decision process a lot easier.
Before using the tax calculator, the following information needs to be on hand.
- The salaries that will be paid to the shareholders. Again, these must be reasonable salaries as per the IRS requirements.
- The projected profits for the tax year. This will have to be an estimated figure that will reflect the realistic profits the business will make yearly.
Once the tax calculation has been completed, it should be possible to make a determination of whether S Corp status is the cost-saving option to choose. Only when the tax advantage can counterbalance the cost of running the business, does it make sense to elect S Corp status.
It is also important to note that the IRS has a lot of rules and regulations that S Corps must adhere to. These regulations can be found on the IRS website or the local tax office can also provide the necessary information.
This article has been published in accordance with Socialnomics’ disclosure policy.