What is an S Corporation?
An S Corporation is a tax election (not a separate entity type) that allows a corporation or LLC to be taxed as a pass-through entity. Profits flow to owners via K-1, similar to a partnership. The key advantage: owners who work in the business can split income between a reasonable salary (subject to payroll taxes) and distributions (not subject to SE tax).
How It's Taxed
The S-Corp files Form 1120-S annually. Owner-employees receive a W-2 for their salary and a Schedule K-1 for their share of remaining profits. The K-1 portion flows to Schedule E on their personal return.
Pros
- SE tax savings — distributions are not subject to the 15.3% self-employment tax. If your business earns $150K and you pay yourself $80K salary, only $80K is subject to payroll taxes.
- Pass-through taxation — no corporate-level tax (unlike C-Corp)
- Credibility — corporate structure can help with contracts and clients
Cons
- Reasonable salary requirement — the IRS requires you to pay yourself a "reasonable" salary before taking distributions. Underpaying yourself invites audits.
- Payroll complexity — must run payroll, file quarterly Form 941, annual W-2, etc.
- Formation and compliance costs — state filing, annual reports, payroll service, and typically a tax professional for Form 1120-S
Recommendations
Tip
The S-Corp election generally makes sense when net business income exceeds $50,000–$60,000. Below that threshold, the payroll and compliance costs may exceed the SE tax savings.
The "reasonable salary" test looks at what someone with your experience and skills would earn doing the same work for another company. Document your salary methodology in case of an audit.