The main downsides of an S Corp include strict IRS compliance requirements, such as paying shareholder-employees a "reasonable salary" to avoid audit risks, and rigid limitations on ownership (maximum 100 shareholders, only U.S. citizens/residents). Additionally, they are limited to one class of stock, face higher administrative costs, and are not recognized for state tax purposes in all jurisdictions.
An S corporation does have some potential disadvantages.
The "2% rule" for S Corporations treats shareholders owning more than 2% of the company's stock (or voting power) differently for fringe benefits, classifying them like partners in a partnership, not regular employees; this means benefits like health insurance premiums paid by the S Corp must be included as taxable wages on their W-2, rather than being tax-free, though the shareholder can often deduct these premiums as an "above-the-line" deduction. This rule prevents them from participating in tax-advantaged Section 125 cafeteria plans, making benefits like Health FSAs unavailable on a pre-tax basis.
You choose an S corp over an LLC primarily for significant self-employment tax savings on profits, as S corp owners can pay a reasonable salary (subject to payroll taxes) and take remaining profits as distributions (not subject to self-employment tax). While an LLC offers flexibility, an S corp provides more structure, making it potentially better for larger profits or attracting investors, but it demands stricter formalities and compliance.
Examples of S Corp tax savings
Likewise, the more profit your business earns, the more you'll save. You need to earn at least $40,000 in profit for an S Corp to make sense, though. Otherwise, the costs of forming and running it exceeds the benefits of an S Corp.
Who pays more taxes, an LLC or S Corp? Typically, an LLC taxed as a sole proprietorship pays more taxes and S Corp tax status means paying less in taxes. By default, an LLC pays taxes as a sole proprietorship, which includes self-employment tax on your total profits.
S-Corp reasonable salary is the market-rate compensation you must pay yourself before taking distributions, typically ranging from $40,000-$150,000+, depending on your role, industry, and location. The IRS requires this to prevent payroll tax avoidance, with penalties reaching 20% plus interest for non-compliance.
To avoid double taxation, one option is to structure the business as a “flow-through” or pass-through entity. In this setup, profits bypass corporate taxation and go directly to the business owners. The owners then report and pay taxes on their share of the income at their respective tax rates.
However, while purchasing real property through an S-Corp is legal, there are serious tax implications at play. If your S-Corp owns a residential property and the property is subsequently distributed to a shareholder, including yourself, any financial gains on the property become taxable at an unattractive rate.
Certain types of corporations cannot elect to be S corporations, including certain financial institutions, insurance companies, and international sales corporations. The corporation must elect to be an S corporation by filing IRS Form 2553.
How do S corp owners pay themselves? Those who are both an employee and a shareholder in an S corporation generally pay themselves via distributions and a salary. The latter is necessary if the individual performs more than minor services for the business.
As such, losses pass directly to shareholders as well. That means shareholders can use losses in an S corporation to offset their personal income, thus reducing their tax liability. However, there's an important caveat here. They can offset losses only to the extent they have basis in the entity.
Even if an S Corp has no income, it must file IRS Form 1120S annually to maintain compliance. Filing establishes a tax record, prevents IRS assumptions about tax liability, and avoids penalties. Business expenses can still be deducted, potentially resulting in a loss that carries forward.
The most tax-efficient way for many active LLC owners is to elect S-corporation status, paying yourself a "reasonable" W-2 salary subject to payroll taxes, with remaining profits taken as distributions (dividends) not subject to self-employment tax, saving ~15% on the distribution portion. For single-member LLCs or those with lower profits, owner's draws (flexible withdrawals) are simpler but all profits are subject to self-employment tax, while a salary-only approach (default LLC/sole prop) also taxes all net income at full self-employment rates. Always consult a tax professional, as the best method depends on your specific income and business structure.
No, an S Corp doesn't need two owners. A one owner S Corp is perfectly legal and quite common. The IRS allows S Corporations to have up to 100 shareholders, but there's no minimum requirement.
You choose an S corp over an LLC primarily for significant self-employment tax savings on profits, as S corp owners can pay a reasonable salary (subject to payroll taxes) and take remaining profits as distributions (not subject to self-employment tax). While an LLC offers flexibility, an S corp provides more structure, making it potentially better for larger profits or attracting investors, but it demands stricter formalities and compliance.
Your S corporation can have a net loss for the year and do something that causes a salary. And if the IRS and/or the courts find that your S corporation did not pay you reasonable compensation, you can experience a new surprise salary, payroll taxes, and penalties. This will make your bad year worse.
How far back can the IRS go to audit my return? Generally, the IRS can include returns filed within the last three years in an audit. If we identify a substantial error, we may add additional years. We usually don't go back more than the last six years.