A subchapter S corporation is an IRS approved and regulated business organization. To qualify, a business must comply with several restrictions. These restrictions include the business only being allowed to have 100 or fewer shareholders, none of which can be partnerships or corporations. S-Corp shareholders are also prohibited from owning preferred shares in the business. S-Corps are prohibited from participating in certain industries, such as insurance. These restrictions may make it more difficult to obtain investment, but for many businesses, the advantages of being an S corporation outweigh any disadvantages from the S-Corp regulations.
A standard corporation first pays taxes on income it has earned during the year. Then, when the corporation issues the income it earns as dividends, shareholders must pay taxes on what they receive. This means corporate income is essentially taxed twice. In comparison, when an S-Corp earns income, it is divided amongst its shareholders based on how much stock each owns. The shareholders report their share of the income on their personal income tax returns and pay taxes on it. When the shareholders receive a distribution of cash from the S-Corporation, it does not have to pay taxes on this amount. As a result, the S-Corp is only taxed once.
Since S-Corp shareholders often work as employees of the business, they have to pay self-employment tax. Self-employment taxes are similar to payroll taxes and are used to fund Social Security and Medicare. While an S-Corp shareholder-employee is required to pay himself a reasonable wage based on the work he does for the business, he only has to pay self-employment tax on those wages. In comparison, sole proprietors or members of a partnership have to pay self-employment tax on their share of all of the business’s income. For example, a business has one owner that pays himself a $50,000 salary but whose business earns $100,000. If the business is an S-Corp, the owner has to pay self employment tax on $50,000. If the business is a sole proprietorship, he must pay self-employment tax on $100,000.
Avoidance of Excessive Compensation Claims
Excessive compensation is an issue with ordinary corporations because those businesses are allowed to deduct wages from their taxable income. If the corporation is paying excessive compensation to a shareholder-employee, it can effectively diminish its own tax burden while allowing the recipient of the excessive wage to avoid paying tax on the “dividend” that is included in the amount he receives. If the IRS believes a corporation is paying excessive wages, it may fine the corporation and the recipient of the wage. Since S-Corps are not taxed and most shareholder-employees do not want to pay the additional self-employment tax, excessive compensation claims are less of an issue. As a result, S-Corps are subject to fewer excessive compensation claims than their ordinary corporate counterparts.
Maintains Corporation Benefits
Most S corporations are simply normal corporations that are specially registered with the IRS. Other than how it is taxed, most S corporations retain all the benefits of being an ordinary corporation. These benefits include shareholders generally not being personally liable for the business’s liabilities and the corporation being able to exist indefinitely regardless of who owns the S-Corp’s stock.