S Corporations: Key Tax and Non-Tax Considerations for Entrepreneurs

Closely-held businesses of all sizes are often structured as an S corporation: an entity structure that passes business income, losses, credits, and deductions through to the shareholders of the business. 

S corps offer attractive benefits to solo businesses as well as other family and closely held businesses, avoiding the double layer of taxation that many view as a drawback to C corporations. While the tax treatment is different, S corporations do provide their owners with many of the same benefits as a C corporation, including limited liability. 

Because of these benefits, S corporations are an appealing business structure for many business owners. However, due to the limitations on the number and types of shareholders allowed, an S corp may not be a fit for all businesses, particularly those with large-scale growth ambitions that include more robust equity structures. 

This overview serves as an introduction to S corporations, outlining the key benefits and drawbacks that business owners should be aware of before choosing to structure their business as an S corporation. 

This article is part of our series on entity selection. View our other articles here:

• The Importance of Entity Choice
• An Overview of the Sole Proprietorship Entity Structure
• An Overview of C Corporations: Tax and Non-Tax Considerations
• S Corporations: Key Tax and Non-Tax Considerations for Entrepreneurs
• Partnerships: What Entrepreneurs and Business Owners Need to Know
• Factors to Consider When Choosing Entity Structure – Smith and Howard (smith-howard.com)

What is an S Corporation?

Legally, an S corporation is a C corporation or other qualified entity that has elected to be taxed as an S corporation. Under Subchapter S of the Internal Revenue Code, businesses that elect this designation may pass business income, losses, credits, and deductions directly to their owners without paying federal taxes at the corporate level. 

It is important to note that an S corporation is not a legal business structure. It is instead a tax designation or tax status. While C corporations or LLCs are both types of legal entities, an S corporation is a tax designation that may be elected with certain added advantages and restrictions.

S corporations are considered a pass-through entity since all profits are taxed at the individual shareholder level. The shareholders are required to pay taxes on the income from the S corp at the applicable federal and state rates. 

In order to elect the S corporation status you must meet the criteria specified under Subchapter S of the Internal Revenue Code. This criteria provides that an S corporation cannot have more than one hundred shareholders, and these shareholders may only be individuals that are considered legal residents of the United States, certain types of trusts or estates, or certain types of tax-exempt organizations.  

Additionally, S corporations are only permitted to have a single class of stock and must be incorporated in the United States. Finally, the business cannot be an “ineligible corporation,” defined as certain financial institutions, insurance companies and domestic international sales corporations.

Tax Considerations for S Corporations

One of the primary benefits of S corporations is that their profits are only taxed once: at the shareholder level (assuming the entity has always been taxed as an S corporation.) This, combined with some additional tax benefits we’ll explore below, can deliver significant tax savings for business owners. 

The profits generated by an S corporation will be taxed at the shareholder level according to the graduated rates applied based on filing status and income level. Business owners can characterize their income from the business in two ways: salary and distributions. S corporation owners are required to pay themselves a reasonable salary, which they pay self-employment and payroll taxes on. Excess profits above this reasonable salary may be paid as distributions.  Distributions themselves are not taxable by the shareholder, however the allocated profit of the business will be taxed at the shareholder level. This income is taxed only at ordinary income tax rates and is not subject to self-employment tax.

The savings offered by this treatment are the key tax benefit an S Corporation offers, but there are additional benefits that should also be considered. 

Provided a shareholder of the S corporation is considered an active participant in the business’s operations, income from the S corporation is not subject to the 3.8% Net Investment Income Tax (NITT). 

Additionally, S corporation shareholders may deduct 20% of their Qualified Business Income (QBI). There are some limitations to the application of this favorable benefit. If your total taxable income (from all sources) is below $182,100 for single filers or $364,200 for married filers, you may qualify for this deduction. However, if your income is above this threshold, you should work with your tax advisor to determine your eligibility.

Non-Tax Considerations for S Corporations

As we noted earlier, S corporations are similar to other types of corporations, although they are subject to a series of ownership limitations. A business that wants to be taxed as an S corp must first legally form a qualified entity, generally a C corporation or LLC. This may include filing articles of incorporation with the Secretary of State, paying franchise taxes, maintaining records of meetings, and so on. Refer to the corporation or LLC laws in your state of incorporation to clarify these requirements. 

In addition to the compliance requirements described above, the IRS also places a series of limitations on the types of individuals and entities that may be shareholders of an S corporation. This can make it difficult for S corporations to raise capital from external investors since many investor structures are set up under an entity that would be a non-qualified shareholder type for the S corporation structure. 

Once businesses have established themselves as an S corporation, they can change from an S corporation to another type of taxable entity structure should the need arise in the future, but there may be significant adverse tax consequences to consider. You should contact your tax advisor to discuss any change in ownership to avoid any accidental loss of your S election status and therefore the risk of triggering unintended adverse tax implications.

Smith + Howard: Experienced Tax Advisors

For entrepreneurs just starting out, choosing an entity structure is an important decision. An S corporation is often a good fit for businesses whose ownership is qualified or early-stage businesses that wish to receive favorable tax treatment.

At Smith + Howard, our tax advisors boast a wealth of experience advising business owners on the most appropriate entity structure for their goals. Our team brings vast experience serving business owners across a wide range of industries and maturity levels, calling on their in-depth knowledge of the tax code to help entrepreneurs find the solution that best fits their needs. 

To learn more about Smith + Howard’s tax and entity selection services, contact an advisor today.