Tax
S-Corporation (S-corp)
A passthrough tax election (not an entity type) that lets owner-employees split income between salary (subject to FICA and Medicare) and distribution (not). The most common tax structure for profitable, single-owner and family-owner U.S. businesses.
S-corp is a tax election made via Form 2553, not a separate legal entity. An LLC or corporation can elect S-corp tax treatment. Once elected, the entity files Form 1120-S annually, issues K-1s to each owner, and follows the reasonable-compensation rules for owner-employees.
The election lets owner-employees pay themselves a 'reasonable salary' (subject to payroll tax) and take the rest as a distribution (not subject to payroll tax). For owners with profits well above a reasonable salary, this can save meaningfully on self-employment tax — commonly $8k-$15k per year for a $200k profit-taker in a middle-tier state, and materially more at higher profit levels.
The math depends on three things: (1) what a defensible reasonable salary is for the owner's role and industry, (2) the state tax overlay (California's 1.5% S-corp tax adds friction; many other states have none), and (3) the coordination with §199A QBI, where too-low a salary limits QBI's wage-based cap. The optimum is rarely intuitive — model annually, especially after a profit inflection.
The election has real ownership constraints that catch people mid-flight: no more than 100 shareholders, all must be U.S. individuals or certain trusts (no foreign owners, no corporate owners, no most-partnership owners), and only ONE class of stock (economic differences in distributions or liquidation preferences bust the election). A raise from an investor requiring preferred stock, or a founder moving abroad, can accidentally revoke S-corp status.
Payroll compliance is the ongoing tax the S-corp collects. Owner comp must run through a real payroll system (Gusto, ADP, QuickBooks Payroll), quarterly 941s must file, and W-2s must issue by January 31. Owners running distributions without a payroll process are the number-one S-corp reasonable-comp exam target.
Common pitfalls
- Underpaying yourself a reasonable salary to maximize distributions invites IRS challenge — reasonable comp is heavily litigated and losses are expensive
- California's 1.5% S-corp tax (minimum $800) reduces the savings significantly for CA businesses
- Restrictive ownership rules (no foreign owners, no entity owners, single class of stock) — a founder moving abroad or a preferred-stock raise busts the election
- Skipping payroll entirely for owner comp; the IRS treats distributions as wages if there's no payroll process, adding back-tax, penalty, and interest
- Missing the Form 2553 late-election relief window (Rev. Proc. 2013-30) for a start-of-year election — the do-over exists but only if applied for on time
Related service
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