Demystifying the S Corp: What is an S Corp?
In this post, our Atlanta business attorney clarifies what an S Corp is and when you may want to consider using one.
What is an S Corp?
Contrary to popular belief, an S Corp is not an actual business entity. No one actually "has" an S Corp. Rather, an S Corp is a form of taxation. Most business owners who say that they have an S Corp typically mean they have a limited liability company or a corporation which they have elected to be taxed as an S Corp.
To begin to peel the back the onion on this issue, all entrepreneurs should understand that businesses can either choose to pass taxes on to its owners (thus the term "pass through entity") or choose to have the business entity itself pay taxes. If you are a single owner pass through entity, then you pay taxes as a "disregarded entity," simply meaning that all profits are reported on the owner's individual tax returns and paid at the individual level. If your pass-through entity has two or more owners, then it is taxed as a partnership under which the profits and losses are allocated amongst the owners. Typically, limited liability companies are taxes as a disregarded entity or partnership, unless they elect to be taxed as a C Corp or an S Corp.
How Do S Corps Pay Taxes?
In essence, S Corps are another form of pass-through taxation; the entity itself is not taxed. However, the most important distinction between S Corp taxes as opposed to being taxed as a disregarded entity or partnership is self-employment taxes. When you operate a business that is taxed as a partnership or disregarded entity, 15.3% of all profits are paid to the IRS in self-employment taxes, regardless of whether they are distributed to the owners. 12.4% of this tax is a social security tax, while the other 2.9% is a Medicare tax. However, the 12.4% social security portion of the tax caps out at $142,800 as of the year 2021, which means that only the 2.9% Medicare tax will be assessed on profits above $142,800.
However, when operating an S Corp, the self-employment tax does not necessarily have to be assessed on all profits. Rather, under an S Corp, an owner can pay itself a reasonable salary (subject to the self-employment tax), and then distribute additional profits to its owner, which are not subject to self-employment taxes. However, the reasonable part is key. The IRS can and will assess self-employment taxes on distributions outside of the owner’s reasonable salary if the salary is not reasonable i.e., commensurate with the work being performed.
Which Businesses Should Elect S Corp Taxation?
Generally, businesses which can profit significantly above the amount equal to the owner’s reasonable salary should consider being taxed as an S Corp. For instance, let us say you run an engineering firm and assume that engineers performing similar work in this field are paid an average salary of $100,000 per year. However, your firm is expected to profit $200,000 per year. If your firm was taxed as a disregarded entity, then generally self-employment taxes will be assessed on the total $200,000 profit. However, under an S Corp, you could choose to pay yourself a reasonable salary of $100,000 per year, and pay yourself the other $100,000 as a dividend, which will generally not be subject to self-employment taxes. Thus, even considering the cap on social security taxes, your business could save substantially by electing to be taxed as an S Corp.
Our Business Attorney in Atlanta Can Assist You in Starting a Business
It is important to note that while our Atlanta business lawyer routinely represents clients in starting a business, Randol Law, LLC does not specialize in tax law and is not an accounting firm. All individuals starting a business should always consult with tax counsel or an accountant to ensure they elect the form of taxation that best suits their business’s needs.
Please contact our Atlanta business attorney to see if representation is right for you in starting your business.