S corporation tax benefits: Balancing opportunities and challenges to be aware of

Ines Zemelman, EA

• 29.04.24 • 5 min read

For small business owners contemplating the appropriate legal structure for their enterprise, the S corporation offers a blend of pass-through taxation and corporate liability protection.

This entity type, recognized under Subchapter S of the Internal Revenue Code, is designed to support small businesses by avoiding the double taxation typically faced by C corporations.

However, while the S corporation structure presents significant tax advantages, it also comes with its own set of challenges that require careful consideration.

Understanding S corporations

What is an S corporation?

An S corporation functions similarly to a traditional corporation with key distinctions in its tax treatment.

It allows profits, and some losses, to be passed directly to the owners' personal income without being subject to corporate tax rates.

This structure not only simplifies the tax filing process but also eliminates the burden of double taxation, where income is taxed at both the corporate and shareholder levels.

How to qualify as an S corporation?

To elect S corporation status, a company must meet the following IRS eligibility criteria:

1. Must be a domestic corporation.
2. Have only allowable shareholders, which include individuals, certain trusts, and estates, but not partnerships, corporations, or non-resident alien shareholders.
3. Have no more than 100 shareholders.
4. Have one class of stock.
5. Not be an ineligible corporation, such as certain financial institutions, insurance companies, and international sales corporations.

Tax advantages of S corporations

Pass-through taxation

A standout feature of S corporations is their pass-through taxation status, where the entity itself is not taxed on its profits.

Instead, profits and losses are passed directly to shareholders who then report them on their personal income tax returns.

This method can be particularly advantageous for shareholders who might fall into lower tax brackets.

Key points:

• Direct tax savings: By avoiding corporate tax, all income is taxed only once at the individual's rate.
• Flexibility in income reporting: Shareholders can use business losses to offset other personal income, such as wages from other employment, potentially lowering their overall tax burden.

Protection against double taxation

Unlike C corporations, where profits are taxed at both the corporate and shareholder levels when dividends are distributed, S corporations only subject shareholders to tax at the individual level.

This single-level taxation is crucial for enhancing the profitability and distribution efficiency of the business.

Reduced self-employment tax liability

One of the most significant benefits of an S corporation is the potential for reduced self-employment taxes.

Profits distributed as dividends are not subject to self-employment taxes, thus potentially reducing the total tax liability of the shareholders.

How it works:

• Salary vs. dividends: Shareholders may receive both a reasonable salary (subject to employment taxes) and dividends (typically not subject to self-employment taxes).
• Tax planning strategy: The IRS requires that shareholder-employees receive a reasonable compensation for their work. If the salary is too low compared to the dividends, the IRS may reclassify all earnings as wages, subjecting them to higher taxes.

Real-world application:

Comparison of tax burden between entity types

*Note: Effective tax rates can vary based on income levels and specific tax situations.

Tax disadvantages of S corporations

Strict eligibility requirements

The S corporation’s eligibility requirements can restrict its practicality for some businesses.

The limitation on the number of shareholders and the prohibition against non-resident aliens as shareholders can limit capital raising opportunities and the company’s growth potential.

Salary vs. dividend scrutiny by the IRS

The IRS closely monitors how S corporations pay their shareholders, who work as employees, to ensure that the compensation is reasonable compared to industry standards.

If the IRS deems the salaries unreasonably low and the dividends disproportionately high, it may reclassify dividends as wages, potentially resulting in higher taxes and penalties.

Loss of flexibility in ownership and profit distribution

Unlike LLCs, S corporations have a rigid structure in terms of profit distribution and shareholder rights.

All shareholders must receive dividends proportional to their ownership stakes without the flexibility to allocate profits and losses in a manner that might better reflect the actual economic investment of the shareholders.

Bottom line

S corporations represent a compelling option for small businesses aiming to combine the legal security of corporate status with the tax efficiencies of a pass-through entity.

The decision to form an S corporation should be based on a comprehensive analysis of the business’s specific needs, projected growth, and the financial implications for its shareholders.

By understanding both the benefits and the restrictions of the S corporation structure, business owners can make an informed choice that aligns with their strategic objectives and tax efficiency goals.

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.