S Corp and Self Employment Tax: What you need to know — Collective Hub (2024)

What is an S Corp?

An S Corp is a tax designation, usually elected by LLCs.

Many sole proprietors form an LLC when they want personal liability protection or to keep their personal assets and credit profiles separated from the actions of their business. Then, they can choose to be taxed as an S Corp for the tax benefits. It’s also a popular designation for a business with several owners or partners who want to avoid the “double taxation” that happens with a C Corp tax designation.

Are you eligible for an S Corp? Here are some of the basic S Corp requirements:

• There can be no more than 100 shareholders.
• There can be no more than one stock type; “preferred” or tiered stocks are not allowed.
• Shareholders must be U.S. legal residents or citizens.
• The S Corp cannot be owned by another LLC, C Corp, or partnership.
• The nature of the business activity must meet certain criteria; some financial institutions, domestic international sales corporations, and insurance companies aren’t eligible.

Sole proprietorship vs S Corp

We’ve already shared how moving from a sole proprietorship to an LLC with an S Corp tax status gives you the benefits of legal and asset protection. Beyond that, some like the tax benefits of an S Corp, too. Specifically, S Corps can pay out a portion of the owners’ income as salary. Why is this important?

The salary is taxed as employment income, which is subject to FICA payroll taxes (15.3% of your gross wages). Your S Corp pays half of this amount (7.65%) as employer taxes and gets to write them off as a business expense. You pay the other half (7.65%), and these taxes are withheld from your paycheck, along with your income tax.

If 15.3% sounds familiar, it’s because the self-employment tax you pay as a sole proprietor is 15.3% of your taxable earnings.

So, what’s the tax benefit of an S Corp?

The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes. Those profits are only subject to income tax.

Here’s an example:

If you make $100,000 in earnings from your S Corp, you can have that income paid out as $50,000 in salary and $50,000 in profit. You’ll pay FICA payroll taxes (15.3%; yes the same amount as self-employment tax) on just $50,000 instead of the whole $100,000. The remaining $50,000 of your income is only subject to income tax.

The benefits of an S Corp include some pretty significant perks, but among the S Corp advantages, the self-employment tax savings is the one business owners seem to like best.

More S Corp and self employment tax considerations

Before you jump on board with the S Corp, there are a few more things to think about.

First, while the self-employment tax savings is significant, it’s just one part of the taxes you’ll be paying. You still have to pay income taxes on the salary and profit that you earn.

Depending on where you live, this can vary. Don’t forget to add the payroll taxes or self-employment taxes you’ll owe in either an S Corp or sole proprietorship arrangement to the income taxes you’ll owe (both federal and state). Some taxpayers fail to include this in their calculations, and it’s a big number to pay attention to.

Another crucial factor is what the IRS calls a “reasonable salary.” That $50,000 we mentioned in our example above assumes that $50,000 is a reasonable wage to pay you for your hours worked and duties performed. There’s no one-size-fits-all guidance for calculating your S Corp salary, and you’ll have to determine what is reasonable for your situation.

The IRS wants to be sure this perk isn’t exploited by underpaying your salary and claiming most of your income as S Corp profits. If your reported salary seems too low, especially compared to your profits, the IRS may flag you. Researching similar job positions and their salaries could prove beneficial here.

Finally, there are some states that charge additional fees or taxes to S Corps that aren’t applicable to sole proprietors. For example, California requires a 1.5% tax on net earnings or $800 minimum payment, payable every year after the first year. When adding up potential savings, don’t forget the costs of doing business as a corporation, including licenses, filing fees, and special taxes.

Do S Corps get 1099 forms?

S Corps don’t pay corporate taxes the same way as C Corps do. Instead, the profits pass through to the owner’s tax return and then the owner pays income tax on the profits. Each year, the S Corp must file a corporate tax return called Form 1120-S. The S Corp filing deadline is March 15, and like your individual return a 6-month extension can be applied for.

The S Corp also files a Schedule K-1 for each shareholder, reporting their individual profit or loss, and gives a copy to each shareholder. The shareholder reports the profit or loss from Schedule K-1 on their individual taxes, usually on Form 1040. Shareholders will also use their K-1 information to file their state income taxes.

How a shareholder uses the Schedule K-1 is similar to how a sole proprietor uses Form 1099-MISC. Information from both forms must be reported on their personal tax returns.

How do I become an S Corp?

If you’re sold on the idea of an S Corp, there are a few things you’ll need to do in order to start.

If you’re a sole proprietor, you’ll need to become an LLC first. Then you’ll file Form 2553 with the IRS to request the S Corp tax designation.

The S Corp election deadline is 75 days after you wish the S Corp status to take effect, although don’t fret if you want this benefit to be retroactive, the IRS is flexible with late elections. You’ll also need an Employer Identification Number (EIN) to fill out the forms for taxation, payroll taxes, and corporate records.

If you’re already an LLC, you can still request S Corp tax status by completing Form 2553. You’ll need to submit the form as soon as possible and it can be submitted with the tax return of the first tax year you want S Corp status to be effective.

Since forming an LLC is done at the state level, and the S Corp designation is done with the IRS, many business owners find it easier to let someone do this for them. A reputable company like Collective can help you assess if an S Corp is the right choice for your company, get you set up with the proper paperwork, and ensure everything is filed on time.

S Corps do require some record-keeping, but it’s nothing like what a C Corp might deal with. You also avoid “double taxation,” one of the major drawbacks to the C Corp lifestyle. You’ll need to pay quarterly payroll taxes for your employees, even if they are shareholders, and remember to give out W-2s to employees. Profit and losses to shareholders are reported on Schedule K-1s so they can include these on their personal income tax payments as well.

There could definitely be some perks to the S Corp lifestyle. Start by forming an LLC for your business, then file Form 2553 with the IRS for S Corp tax status. If you find the process time-consuming or confusing, there’s help for business owners like you. Often, the best way to get the benefits of this S Corp and self employment tax structure is to outsource the paperwork to a professional, so you can focus on keeping on with your business.