S Corporation & Taxes

To understand how S Corporation taxes work, it is important to note that an S corporation is not a separate corporate entity, but rather a special IRS tax classification that can apply to LLCs, partnerships, and other corporations. The benefit of forming an S corporation, then, is to take advantage of a tax structure that can save your business money.

S Corporations are exempt from both federal income taxes and self-employment taxes. Instead, the business’ owners pay themselves and each shareholder-employee a salary, which is then claimed as income on their individual tax returns. Any remaining profit is then distributed as dividends to the shareholders. If an S corporation shows no profit or a loss, shareholders deduct the loss from their federal taxes and receive the benefit of falling into a lower tax bracket. Each shareholder also claims a portion of the business’ expenses and credits on their personal tax returns. The value of the company’s product inventory, for example, can count toward income for tax purposes. This setup spares S corporations not only the federal tax burden, but also the burden of expenses and losses that often plague small businesses early in their inception.

Like any other business, S corporations must pay Social Security and Medicare (FICA) taxes on the wages distributed to employees. However, the ability to divide the business’ profits into wages and dividends often reduces the FICA tax burden by thousands of dollars since FICA taxes are only levied against wages. For example, a C corporation making a profit of $100,000 must pay 7.65 percent in FICA taxes on the entire amount, or $7,650 in taxes. The owner of an S corporation claiming $50,000 in income out of a business profit of $100,000 is only required to pay FICA taxes on the $50,000–a payment of just $3,825. The remaining $50,000 can be claimed as dividends, which are taxed lower than income.

However, these are not the only taxes S corporations may be subject to. Some states treat S corporations as C corporations for tax purposes, requiring S corporations to pay a certain percentage of their profits or dividends in taxes to the state. Business owners wishing to form an S corporation should check their state’s business laws to see what they may be required to pay. Regardless, forming an S corporation is often a great way to avoid the federal tax burden in the early life of your business.