S corporation examples are critical to helping you understand how an S corporation works, how it’s formed, and what unique tax benefits it receives.
In this post, we will discuss how an S-Corp works and also review a few examples. You should then have a good understanding of S-Corps and decide if it is time to implement one for your business.
How does an S-Corp work?
An S-corporation, also known as an S-corp, is a type of business structure that allows business owners to avoid double taxation. Unlike a traditional corporation, where profits will be taxed at the corporate level and once again when distributed to shareholders, an S-corp allows profits and losses to be passed through to shareholders and reported on their individual tax returns.
This means that the business itself does not pay federal income taxes. Instead, shareholders report their share of the business income (or even losses) on their individual tax returns and pay taxes accordingly.
To qualify as an S-corp, the company must meet specific criteria, such as having no more than 100 designated shareholders, all of whom must be U.S. citizens or permanent residents. Additionally, S-corps must follow certain rules regarding corporate governance, such as holding regular meetings and keeping proper records. Shareholders must also receive reasonable compensation for their services and cannot use the company’s profits as a way to avoid paying employment taxes.
One key advantage of an S-corp is that it provides limited liability protection for shareholders, similar to a traditional corporation. This means that shareholders are not personally responsible for the company’s debts or liabilities, and their personal assets are protected in the event of a lawsuit or other legal action against the business.
Additionally, S-corps may be more attractive to investors and lenders since they offer the benefits of a corporation while still allowing profits and losses to be passed through to individual shareholders. Overall, an S-corporation can be a flexible and tax-efficient way to structure a small or mid-sized business. Still, it is important to consult with a legal or financial professional to determine if it is the best choice for your specific circumstances.
Example of S Corporation Taxation
XYZ Inc. is an S corporation owned 30 percent by Phil and 70 percent by Jim. If the company has a net income of $100,000 in a year, Phil will report $30,000, and Jim will report $70,000 as income on their tax returns.
If the corporation retains the income instead of distributing it, Phil and Jim will still have to pay tax on the profit. However, they do not have to pay taxes later when the corporation distributes this income to them.
Let’s take another look
Let’s say that Sarah and John start a software development company and decide to structure it as an S-corporation. They each own 50% of the company’s shares and serve as co-CEOs. In the first year of operations, the company earns a profit of $200,000.
Under S-corporation rules, the company does not pay federal income tax on this profit. Instead, Sarah and John report their share of the profit on their personal tax returns. If they each received a salary of $100,000, their total taxable income for the year would be $200,000 (their share of the company’s profits) plus $100,000 (their individual salaries), for a total of $300,000.
| S-Corp | C-Corp | Partnership | Sole Proprietor |
|---|---|---|---|
| Form 2553 Election | Files Form 1120 | Pass-Through Taxation | Schedule C |
| Files Form 1120-S | Double Taxation | Issues K-1 | Subject to Employment Tax |
| Officer W2 | Officer W2 | Files Form 1065 | Simple to File |
| Pass-Through Taxation | Dividend Taxation | No Officer W2 | Included on 1040 |
Assuming a combined federal and state tax rate of 30%, Sarah and John would owe $90,000 in taxes on their individual incomes. However, they would not owe any additional taxes on the $200,000 profit earned by the company, since it was already taxed at the individual level.
In subsequent years, if the company were to have a loss instead of a profit, Sarah and John would be able to deduct their share of the loss on their individual tax returns, which could help to reduce their overall tax burden.
Overall, this example illustrates how an S-corporation can allow business owners to avoid double taxation and potentially lower their tax liability by passing profits and losses through to individual shareholders.
A simple illustration
Let’s say that Jane and John are partners who run a successful small business selling handmade jewelry. They decide to incorporate their business as an S-corporation to take advantage of the tax benefits and limited liability protection. After incorporating, they become shareholders in the S-corp.
In the first year, the S-corp earns a total profit of $200,000. Jane and John each own 50% of the shares, so they are entitled to $100,000 of the profits each. Since S-corps are pass-through entities, the company does not pay any federal income tax on the $200,000 profit. Instead, Jane and John each report their share of the profits on their personal tax returns and pay taxes at their individual tax rates.
If Jane and John decide to reinvest some of the profits back into the business, they can do so without being subject to double taxation. For example, they might use some of the profits to purchase new equipment or hire additional employees. Any remaining profits can be distributed to the shareholders as dividends, which are also taxed at the individual shareholder’s tax rate.
In addition to tax benefits, the S-corp structure provides limited liability protection for Jane and John. If the business were to face a lawsuit or other legal action, their personal assets would be protected as long as they were acting in their capacity as shareholders and not engaging in fraudulent or illegal behavior. Overall, the S-corp structure allows Jane and John to run their business with greater flexibility and protection while still enjoying the tax benefits of a pass-through entity.