What, exactly, is an S corporation?

Business people (and sadly even some accountants and lawyers who should know better) get confused about exactly what an S corporation is. So this is a good question.

I'm also going to throw in some extra general information about S corporations in this answer, figuring that if you're asking this question, that additional trivia may be useful.

Not Necessarily an Actual Corporation

In a nutshell, an S Corporation is a corporation, limited partnership or limited liability company that's made an S election with the IRS.

And, yes, you did just read right. An S Corporation doesn't have to actually be a corporation. It needs only to be what the Internal Revenue Service considers an eligible entity.

You should therefore think about an S corporation not as a "legal entity" but rather as a tax accounting classification.

By the way, to make the election, a business files a 2553 form with the IRS. That form names the corporation, limited partnership or LLC that makes the election and proves to the IRS that all the owners are "on-board" with the election.

Two other quick points about this election: First, you need to have the corporation or LLC or whatever already in existence in order to make the election. Second you need to make the election technically by the 15th day of the third month of the year. (Typically, that means by March 15.)

One other thing: Completing the form is pretty easy--especially for a brand new, one owner business.

Why Subchapter S Status Matters

Just to go into this definition a bit further, the S election tells the IRS that the business wants to be treated under the rules of Subchapter S of the Internal Revenue Code.

While there are many complicated provisions in Subchapter S, the basic feature of an S corporation is easy to understand: S corporation taxable income or S corporation tax deductible loss is allocated to the S corporation owners based on their ownership percentages.

An S corporation that makes, say, $100,000 in profits pays no income taxes on that profit. Instead, the shareholders of the S corporation include the profit on their returns.

If two shareholders equally own an S corporation that makes $100,000, for example, each shareholder adds $50,000 of income to his or her return and then pays the tax on that $50,000 profit from the S Corporation.

Why Small Businesses Even Do This

Let's be blunt about why people choose to operate as an S corporation: Small business owners use S corporations to minimize the amount they pay in payroll taxes.

The S corporation minimizes amounts shareholder-employees pay in payroll taxes because the S corporation profit allocated to a shareholder isn't subject to payroll taxes.

Often shareholders each individually save $5,000 to $10,000 a year in payroll taxes by using the S corporation gambit.

The catch with an S corporation is that the salary you set for a shareholder-employer such as the owner needs to be reasonable.

A low salary might save payroll taxes temporarily, but the IRS should be able to successfully challenge such a salary.

The 1120S tax return, which is what an S corporation files, makes it very easy to see when shareholder-employees are under-compensating themselves. (The first deduction that appears on the 1120S S corporation tax return is the shareholder-employee salaries value.)

Three More Things to Know About S Corporations

Here are three more things to know about S corporations.

First, probably you want to use an LLC as the platform for your S corporation. The LLC platform gives you a bit more flexibility about when you start and stop your Subchapter S corporation.

Second, often you don't want to be an S corporation your first year in business. Often, you want to wait until things get really going and the business makes some amount of profit that's substantially in excess of what would be a fair salary to the owner or owners.

For example, you don't want to run your business as an S corporation if you're making $30,000 or $50,000. You want to run your business as an S corporation when you're making $80,000. Or $180,000. Or, gulp, $800,000.

Third, you probably complicate your business finances by electing S corporation status. You'll need to run a real accounting system (something like QuickBooks). You'll need to do formal payroll (even if the only employee is the owner). And you'll probably complicate your taxes enough that you move beyond being able to do your tax returns yourself.

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Additional Information You May Find Useful

If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.

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