An S Corporation is a designation granted by the Internal Revenue Service to small corporations for tax purposes. To qualify, the business must have fewer than 100 shareholders and is prohibited from participating is certain businesses, such as insurance. The business owner must either be an individual, trust or estate; she cannot be a non-resident alien. Qualifying as an S Corporation can provide significant legal and tax advantages for self-employed individuals.
To qualify as an S Corporation, the business must register as a corporation in the state where it is headquartered. Corporations act as a shield for its owners, or shareholders. As a distinct legal entity for litigation purposes, the corporation is the named party in any lawsuit involving the actions of the business. The shareholder is generally not liable for any of the corporation’s actions, which limits her financial exposure to the amount of money she invested in the business. If the business were established as a sole proprietorship, the owner could be compelled to use her personal assets to pay off any of the business’s liabilities or court-ordered penalties.
For tax purposes, an S Corp is a disregarded entity. This means that the S Corp does not pay any taxes on the income it earns. Instead, the owner reports the business's income and losses on her personal tax return and pays taxes on that income subject to her personal income rate.
Self-employed individuals are required to pay themselves a reasonable salary from an S Corp’s profits. This is to ensure that the owner pays employment taxes on a portion of the money that the business generates. While a self-employed individual is required to pay payroll taxes on some of the business’s income, that tax is not applied to all of the S corporation’s income. In comparison, sole proprietors are required to pay self-employment tax on all income that the business earns. The self employment tax serves the same function as payroll taxes, since both are used to fund Social Security and Medicare. As a result, operating as an S Corp lowers a self-employed individual’s liability for employment taxes.
An S Corp is permitted to report its income by filing Form 1120S with the IRS at the end of its business year. Sole proprietorships must request its customers to file 1099s as proof of the tax year’s transactions. These requirements may pose a burden on customers that may stymie sales.