Definition
An S-corporation is a corporation that passes income through to its owners' personal returns, avoiding corporate-level tax, while allowing owners to take part of their income as salary and part as distributions.
How It Works
The business profit flows to shareholders and is taxed once, on their personal returns. Owner-employees must take reasonable compensation as W-2 wages subject to payroll tax, while remaining profit can be distributed without payroll tax, which is the main tax advantage over a sole proprietorship.
Example
An owner with $200,000 of profit pays themselves a reasonable $120,000 salary and takes $80,000 as a distribution, saving payroll tax on the distribution portion.
When It Works Best
It works best for profitable owner-operated businesses where profit meaningfully exceeds a reasonable salary.
Who It Applies To
Eligible small businesses that elect S-corp status.
Watch-Outs
The IRS scrutinizes unreasonably low salaries, and the reasonable compensation figure also affects the QBI deduction, so the two must be balanced.
