In order to begin an “S corporation advantages” discussion, you need to first understand that an S corporation is not a corporation. Rather, an S corporation is, essentially, a tax accounting approach that federal (and most state) tax laws allow many corporations and limited liabilities to use.
What this means, by the way, is that you can’t simply ask a general question like, “Hey, what are the S corporation advantages?” Rather, you need to be more precise and ask how an S corporation looks as compared to a C corporation or as compared to a partnership or sole proprietorship (which is what LLCs get taxed as when they’re not taxed as S corporations).
Fortunately, as long as you bear the above information firmly in mind, it’s pretty easily to identify the advantages of an S corporation as compared to a C corporation and as compared to sole proprietorships and partnerships.
S Corporation Advantages as Compared to C Corporations
As compared to a traditional corporation, also known as a C corporation, an S corporation delivers three significant benefits:
1. Corporation losses–such as those that may occur in the startup phrase of a business–flow through the corporation and appear on the shareholder’s tax returns as deductions if the shareholders are active in the business. This turns early losses into tax deductions–and can be a huge boon.
2. No federal or state income tax is owed by the corporation on the corporation profits–though individual shareholders will need to report their shares of the corporation profit on their personal returns and pay taxes on those shares.
3. Shareholders can distribute all of corporate profits to shareholders without paying payroll taxes. This is actually the big benefit an S corporation–and called a loophole by some people. Without getting into the politics of this benefit, let me just say that if a regular C corporation wants to pay out all of its profits to shareholders, the common way to do so is by increasing shareholder-employee wages or by paying shareholder-employee bonuses. These methods do extract the profits, but the shareholders pay both income taxes and payroll taxes. With an S corporation, though, no payroll taxes are owed. Only income taxes.
S Corporation Advantages as Compared to Sole Proprietorships and Partnerships
As compared to sole proprietorships and partnerships, an S corporation delivers two significant benefits:
1. While sole proprietors and active partners in “business” partnerships pay self-employment taxes on all of their income, S corporation shareholders typically only pay employment taxes on the part of the profit that they specifically call out as wages. And this “loophole” commonly saves several thousand dollars a year in employment taxes–even when the S corporation shareholder plays by the rules.
Note: The advantage discussed in the preceding paragraph is really the same benefit as #3 in the S corporation versus C corporation discussion.
2. Some business-related tax deductions for sole proprietorships and partners appear on their personal tax return as adjustments for adjusted gross income–including pension fund contributions and self-employed health insurance. But this treatment means that the deductions save only income taxes and not self-employment taxes. In comparison, in an S corporation the same deductions appear on the business tax return and as a result reduce not only income taxes but also employment taxes. This typically saves at least several hundred dollars a year and may save thousands of dollars a year in some circumstances.
Note: One other S corporation advantage arguably exists when you compare an S corporation to a partnership or to a limited liability company treated for tax purposes as a partnership. An S corporation’s accounting is simpler. S corporations can have only one class of stock. Profits get allocated purely on the basis of ownership percentages. The rules about what happens when the corporation borrows money to use for tax deductions (also known as “loan basis” rules) are easy to apply. And all of this stuff means that S corporation bookkeeping and tax returns are easier than partnership bookkeeping and tax returns.