An S-corp (also called a Subchapter S corporation) is a small corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders’ personal tax returns. The same rules apply to members of an LLC that have chosen to be taxed as an S-corp.
S-corps distribute earnings to shareholders. Those distributions aren’t considered salary or wages, so they’re not subject to payroll taxes. But you can only make distributions to shareholders after you’ve paid shareholder-employees reasonable compensation for work they’ve done. That includes paying yourself.
Salary, including health insurance and other fringe benefits for officers or shareholders owning more than 2% of the corporation’s stock, should be included on the shareholder-employee’s Form W-2.
Once a reasonable salary has been paid to the shareholder-employee, all additional payments can be made as distributions. Distributions are subject to income tax, but not payroll taxes.
By paying reasonable salaries to its shareholders as required, the S-corp can avoid having their tax-favored distributions questioned by the IRS and reclassified as salaries. And while those salaries are subject to employment tax, those taxes are deductible by the S-corp.
Advantages to the corporation are:
- You avoid IRS scrutiny and a potential audit
- You can deduct salaries/wages and the associated payroll taxes as business expenses, which you can’t do with distributions
- You can take advantage of business deductions for company contributions to retirement plans, group health insurance, and Health Savings Accounts (HSAs)
- Paying wages shows company stability and increased creditworthiness
Advantages to the employee-shareholder are:
- Withholding provides credits to Social Security and Medicare programs
- Health insurance premiums paid may provide an adjustment to income, which is more valuable than the itemized deduction on the personal tax return
- Paying salary and employment taxes makes income verification easier
- You're eligible for unemployment