Tax Benefits for S Corporations – Lexology

Both tax and non-tax considerations should be taken into account when determining how you want to structure your business. Corporations, both C corporations and S corporations, and limited liability companies (LLCs) offer distinct advantages over operating as a sole proprietorship or partnership.

These non-tax benefits include

  • Increased credibility, making it easier to obtain investment capital
  • Protection of your non-commercial assets against commercial creditors
  • Increased ability to plan business succession

However, there are also many tax benefits that can be obtained by incorporating or forming an LLC. These tax benefits vary from entity to entity. This article discusses the tax benefits of operating your business as an S corporation.

C and S corporations are taxed very differently

The distinction between a C corporation and an S corporation is purely how they are taxed for income tax purposes. For business law, compliance requirements and asset protection, they are identical. But when it comes to income tax, an S corporation is very different from a C corporation.

C corporations get this name because they are governed by subchapter C of the income tax provisions of the Internal Revenue Code. S companies are governed by sub-chapter S of the same Code.

To qualify by the IRS as an S corporation, a corporation files an election with the IRS using Form 2553 (Election by a Small Business). See our article How to Make an S Corporation Election for more information on when and how to file Form 2553.

This choice affects the company’s taxes in two main ways:

  • Income tax (federal and state)
  • Self-employment and employment tax

S corporation income is taxed on shareholder tax returns

As a result of this election, an S corporation does not pay corporate level income tax. In an S corporation, all profits, losses, and other tax items flow through to shareholders and are allocated to each shareholder based on that shareholder’s proportionate share of stock. This means that a shareholder with 50% of the shares must declare — and pay taxes on — 50% of the company’s income, losses, deductions and credits.

This is an important distinction between operating as an S Corporation and operating as a Limited Liability Company (LLC). An LLC operating agreement may allocate different percentages (or even changing percentages over time) of different tax elements to different members, regardless of their ownership percentage. Thus, a member can be allocated 40% of the profits and 60% of the losses during the first three years of a business, and 60% of the profits after the third year.

Running an S corporation can reduce employment tax

In addition to paying income tax, everyone must also pay some type of employment tax on their earnings during the year. An employee is liable for FICA (Federal Insurance Contribution Act) tax on half of the remuneration received. The employer withholds this amount and pays it on behalf of the employee.

The employer must also pay his share of tax on the other half of the compensation. In the case of a C corporation, the shareholders are not considered self-employed, even if they work for the corporation.

Self-employed individuals – which includes those who operate their business as an LLC – must pay the Self Employed Contributions Act (SECA) tax on the total amount of their self-employment earnings. When all income from the LLC passes through to the owners, self-employment tax is due on the entire amount. There is a compensatory deduction that restores parity between employees and the self-employed.

With a pass-through entity – whether it’s an LLC or an S Corporation – all income is considered distributed, even if the owners have chosen to keep it in a business bank account. For example, if an S corporation with three owners has income of $300,000, each owner would have to report $100,000 on their tax return. This is true even if there is $150,000 left in a business bank account. The ability to accumulate income is one of the characteristics of a C corporation.

Operating as an S corporation offers a way to reduce the amount of self-employment tax owners have to pay, as an owner can also be an employee of the business. This means that employee-owners can receive money from the company in two ways:

  • Dividends: No labor tax is due on sums received as dividends.
  • Salary: Employment taxes must be paid on amounts received as salary.

By using a combination of dividends and salary, an S corporation owner can reduce self-employment tax and generate payroll deductions that will reduce the amount of business income. This is also a major difference between being taxed as an S corporation and being taxed as an LLC taxed under the default rules. (A single-member LLC is not considered an entity, and a multi-member corporation is taxed as a partnership.) LLC members are considered owners, but not employees.

The S corporation’s allocation between salary and dividends must be reasonable. In other words, the salary must correspond to what would be paid for comparable work performed by someone with comparable skills and experience.

The IRS looks closely at transactions between shareholders and their S corporation, particularly if those transactions have the potential for tax evasion. The more shares you own and the more control you have over the company, the more scrutiny the transaction is likely to be.


It’s unwise to choose a business structure based solely on tax considerations, but it’s also unwise to neglect to consider the tax impact of your decision. The combination of transfer taxation, which eliminates any risk of double taxation, and the possibility of receiving both salary and dividends can make the S corporation the best choice from a tax point of view.

However, it is wise to discuss all of your options, including your long-term growth plans, with your business advisors before making the S corporation choice.

Luisa D. Fuller