Choosing the right business structure can have a major impact on how much tax you pay each year. For many small businesses, electing S Corporation status offers one of the most effective ways to reduce tax obligations, without compromising IRS compliance. Understanding how S Corps treat salary, profit, and distributions is essential for any business owner looking to keep more of what they earn.
The Primary Advantage: Reduced FICA Taxes
One of the biggest advantages of S Corporation status is that only your salary as the business owner is subject to FICA taxes (Social Security and Medicare). The rest of your business profit is not considered FICA taxable wages.
The remaining profit, whether you take it as a distribution or leave it in the business, is not subject to FICA taxes. Distributions are generally tax-free as long as you have sufficient stock basis. If distributions exceed your basis, the excess is taxed as a capital gain, not ordinary income. Any profit retained in the business still flows through to your personal tax return, but it is never treated as FICA taxable income.
This structure allows business owners to significantly reduce their tax burden while maintaining full IRS compliance.
The Election Process
Electing S Corporation status involves several steps:
- Form a corporation or LLC in your state
- Obtain an Employer Identification Number (EIN) from the IRS
- File Form 2553 - Election by a Small Business Corporation
- Meet the filing deadline: Generally within 2 months and 15 days of the beginning of the tax year
- Set up payroll for shareholder-employees