Saving Business Taxes with an S Corporation: A Short Primer

S corporations, or Subchapter S corporations, produce several tax benefits as compared to sole proprietorships, partnerships, and C corporations.

The big benefit—and the one that people usually talk about—is the payroll tax savings. To understand how this works, let me compare two alternatives: A sole proprietor making $90,000 a year and an S Corporation making $90,000 a year.

Of course, the taxes that a sole proprietor pays depends on his or her filing status, itemized deductions and family size, but typically such a person might pay about $12,000 in federal income taxes. The person might also pay another chunk in state income taxes.

In addition to these income taxes, the proprietor also pays a 15.3% self-employment tax on the $90,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social security and Medicare tax) equals $13,000.

Things usually work differently for the S corporation, however. To make calculations easy, assume the S corporation is owned by a single shareholder. In this case, the S corporation must break the $90,000 of profit into two buckets: wages and the leftover (which is called a distributive share). If the wages equal $40,000 and the leftover distributive share equals $50,000, the business pays Social Security and Medicare taxes (equivalent to self-employment tax) equal to roughly $6,000.

In this case, even though the two businesses make the exact same amount of money, the S corporation pays roughly $7,000 less in tax each year.

Now, before you rush off, incorporate your business and elect S corporation status, let me add a crucial qualification: Starting in 2011, some small professional service corporations don't get self-employment or payroll tax savings from an S corporation. Congress, in the American Jobs and Closing Loopholes Act of 2010 (perhaps the most inaccurately named tax law of the year) partially closed the S corporation loophole for a couple of categories of professionals. You can read the FAQ article, What is a Disqualified S corporation? for more information.

But let me get back to the subject of the benefits an S corporation delivers to its owners...

S Corporations also provide two other useful benefits--benefits which are a little more difficult to quantify but still important nonetheless.

One such benefit is that S corporation losses (such as those that often occur in the early startup years) can be used as tax deductions on the shareholders personal income tax returns.

Another such benefit is that the S corporation isn't taxed on S corporation profits--at least by the federal government.