By Dan Miller, WCI ContributorThere are many different ways for doctors and other professionals to set up a business, and an S Corporation (S Corp) is one of the most common. While the name “S Corp” is commonly used, it is important to understand that, technically, there is no such thing as an S Corp. Instead, a corporation that wants to be taxed as an S Corp files a document called an “S Declaration.” The “s” in S Corp stands for “small,” as in a small business.
Overview of S Corp Taxation
There are a few things that you need to know about S Corps, and one of them is that they are taxed in a different way than traditional corporations. S Corps are no longer subject to the corporate level of taxation—instead, all of their taxes are passed through to the shareholders of the corporation.
This can be a useful corporate structure for high-net-worth individuals, especially if you work for yourself (or as a partnership with a spouse or partner). The reason for this is due to the way that S Corps are taxed. While shareholders and employees both pay income tax on their distributions or salary, shareholders do NOT pay payroll tax on their distributions. This can lead to significant overall tax savings for single-member S Corps, as we'll discuss further in the next section.
Tax Benefits of an S Corp
One of the biggest tax benefits of an S Corp is that you can divide the earnings of the corporation into salary for its employees and distributions for its shareholders. The main advantage of dividing the corporation's earnings in this way is that you don't pay payroll taxes (i.e. FICA, Self-Employment, or Social Security and Medicare taxes) on distributions.
In an ideal world, you would classify as much of your income as possible as a distribution to avoid these taxes. However, the IRS is aware of this, so you'll want to pay yourself a reasonable salary. There isn't a specific amount that you need to pay in salary, but one guideline is to pay yourself the going rate for what you specifically do. However, there is a fair amount of wiggle room in determining what the going rate actually is, so you may be able to use this to save quite a bit in taxes.
This is only one of the ways to cut your taxes by incorporating as an S Corp — there are a few other tax strategies that you should know. The S Corp may also be able to cover your health insurance premiums, employ your children, or help you earn a home office deduction. It can even be possible to rent your primary residence to your S Corp for up to 14 days in a year without having to report the income. Consult with a tax advisor to see how an S Corp might benefit you.
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S Corp Shareholder Tax Responsibilities
Since an S Corp is a pass-through entity, it is required to fill out the fairly simple IRS Form 1120S form each year. As part of filling out Form 1120S, the S Corp fills out Schedule K-1. The corporation will then give the Schedule K-1 to each of the members of the corporation (this may only be one if you are the sole member and employee of the corporation). These Schedule K-1s are used by each member when they file their own personal tax return.
State-Level Tax Considerations for S Corps
When you file taxes as an S Corp, there are a couple of things to keep in mind. Although S Corps are generally not subject to federal corporate income tax, they can be taxed at the state level, which can vary significantly depending on the state in which the business is incorporated. Not all states recognize S Corps—and if you live in one of those states, the S Corp itself may have to pay taxes (in addition to each member paying income taxes on their salary and/or distributions). Consult with a trusted tax advisor to make sure you are handling the state tax situation correctly.
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Why an S Corp Doesn’t Mix Well with a W-2 Job
The Bottom Line
There can be a host of tax-related advantages to electing to file as an S Corp, especially for physicians and other individuals with a high net worth.
One of the biggest tax advantages to having an S Corp is that S Corps do not pay payroll taxes on distributions. So, a business with an income of $150,000 might pay a salary of $100,000 to its employee(s) and make a distribution of $50,000 to its members (who may be the same person or people). Payroll taxes are due on the $100,000 salary but not the $50,000 distribution. Depending on how much income the business has and how much is classified as a distribution, this can result in significant tax savings. It's important to note that you do need to pay yourself a reasonable salary for the type and amount of work you are doing—if not, you may run a higher risk of an IRS audit. There are also additional advantages to filing as an S Corp, though one potential drawback is the additional time and paperwork that may be required.
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