S-Corp Guide for Small Business Owners

If your business is growing and you’re looking for ways to reduce taxes and operate more efficiently, you’ve probably heard about the S-corporation (S-corp) tax structure. Many small business owners save thousands per year by electing S-corp status — but the rules and requirements can feel confusing at first.

This guide breaks down what an S-corp is, how it saves taxes, and the practical steps required to run one correctly.

What Is an S-Corporation?

An S-corp is not a type of legal entity — it’s a tax election you make with the IRS to change how an LLC or a traditional corporation (aka, C-corp) are taxed.

By choosing S-corp taxation, your business becomes a pass-through entity, meaning profits flow directly to your personal tax return. This is distinct from C-corporations in that profits earned by a C-corp are taxed at the C-corp level, and then again if distributed to the C-corp owner(s). 

Why S-Corps Save Taxes: The Key Benefit for Small Business Owners

1. Major Reduction in Self-Employment Taxes

If you’re already operating as a Sole Proprietorship (Schedule C), the reduction in Self-Employment Tax (“SE Tax”) is the benefit you’ll feel the most. Sole proprietors and standard LLC owners pay SE Tax (15.3%) on business profits up to $176,100. And then 2.9% SE Tax on business profits above that threshold. 

But instead, S-corp owners split business profit into two buckets:

• a reasonable salary, which is subject to the same 15.3% tax rate (only it’s referred to as FICA tax instead of self-employment tax). 

• an owner distributions, which are not subject to self-employment tax or FICA.

Example:
If your business earns $150,000 and your reasonable salary is $80,000:

• Salary subject to payroll taxes: $80,000

• Remainder taken as distributions: $70,000

• Result: avoiding over $10,000 of self-employment / FICA tax.

2. Pass-Through Taxation (Avoid Double Taxation)

If you’re already operating as an C-Corp you’ll immediately benefit from no more double taxation. As a C-corp, taking distributions from business profits (after paying yourself a salary) meant paying another income tax. C-corps already pay a 21% income tax whether you take a distribution of those profits or not. And then if you take a distribution you will also pay individual income tax on that same profit. But S-corps don’t pay corporate federal income tax. Profits “pass through” to your personal 1040 return via a Schedule K-1. 

The state of California does impose a 1.5% “pass through entity” tax. This is an unfortunate CA-specific cost to having an S-corp. However, if you’re an exceptionally high earner (greater than $400K) this pass through entity tax goes from foe to friend, by allowing you to deduct more state taxes than you personally can under the itemized deduction rules.

How to Run an S-Corp Correctly: Operational Requirements

Many businesses get into trouble not by forming an S-corp incorrectly (that part is fairly simple), but by operating incorrectly. Here’s what you must do in an ongoing capacity.

1. Pay Yourself a “Reasonable Salary”

The IRS requires S-corp owners who work in the business to take a reasonable salary before taking distributions. And by salary, the IRS means cutting yourself a legit paycheck with all the appropriate taxes withheld and remitted to the tax authority. I highly recommend getting help in this process.

Determining the dollar amount of the “reasonable salary” takes some thought, analysis, and documentation. A CPA can help you with that. 

Withholding and remitting tax to the IRS and state tax authority, filing quarterly payroll tax returns, issuing year end W-2s…too much headache for a small business owner to deal with on their own. Do yourself a favor and outsource that to a payroll service provider (e.g., Gusto, ADP, QuickBooks).

2. Proper Bookkeeping and Recordkeeping

If I’m advising you to work with a payroll service provider, I’m sort of presupposing you have proper bookkeeping in place already. But sadly I’ve seen many small business owners fail in this department. You need solid bookkeeping. Not only do you need to have a reliable balance sheet and income statement on your hands at all times, but you need careful record keeping of your basis in the S-corp shares, distributions out of the S-corp, and all the journal entries to correspond with your payroll. 

3. Follow Corporate Formalities

The IRS expects corporate-style operations even if your S-corp is just an LLC making a tax election. That means you need to maintain a separate business bank account with absolutely zero comingling of personal expenses and business expenses. 

4. Contract under the S-Corp Name

Suppose you’ve been operating as a Sole Proprietor for a while. And because you haven’t “technically” been a corporation you use a personal checking account to deposit customer payments as you “pay yourself” because your customers make checks out to you, personally.

Under the S-corp structure this will have to change. Clients no longer sign contracts with you, the business owner. They sign contracts with the S-corp and make checks out to the S-corp. 

Is an S-Corp Right for Your Business?

If your business is profitable, you’re paying high self-employment taxes, and you’re ready to handle (or outsource) a bit more structure, an S-corp may be one of the smartest tax moves you can make.

Many small business owners save thousands each year while operating more professionally and efficiently.

If you’d like help determining whether an S-corp is right for you — or need assistance with the election, payroll setup, or annual tax filings — our firm can walk you through every step.