S Corporations

This book is mostly about S corporations, so we saved the best for last. The benefits of an S corporation election include-

• The reduction of self-employment taxes (the big elephant)
• Wages paid to the owner, which can help with the W-2 wage limit on the Section 199A deduction at higher incomes (more on that in a bit)
• Access to the pass-through entity tax (PTET) election in states that offer one, a state-level workaround to the cap on deducting state and local taxes, if you are coming from a sole proprietorship or single-member LLC
• Business activity that moves off Schedule C and onto a separate Form 1120S, changing both the presentation of the business and its tax return filing footprint (yawn)

How Much Does an S Corp Save?

Read that first bullet again. The S Corp election tweaks your income taxes around the edges, but the real savings come from reducing self-employment taxes, which consist of Social Security and Medicare.
As a sole proprietor or single-member LLC, you pay self-employment taxes on nearly all of your business profit. With an S Corp, you pay Social Security and Medicare taxes only on your salary. The remaining business income passes through on your K-1 without self-employment tax. Rev. Rul. 59-221 is one of the authorities behind this distinction, which we discuss elsewhere in this book.

Social Security taxes stop at the wage base ($184,500 for the 2026 tax year and $192,300 for the 2027 tax year), but Medicare taxes continue forever: 2.9% on every dollar, plus an extra 0.9% Additional Medicare Tax once your earned income exceeds $200,000 ($250,000 married filing jointly and $125,000 married filing separately). Don’t laugh! That 3.8% times a zillion dollars is a lot of money.

Spoiler Alert: At $2 million in net income after expenses (profit), your S Corp can still save roughly $50,000 a year even with a $400,000 salary… all because of Medicare taxes.

Other payroll taxes, such as federal and state unemployment, state disability insurance and paid family leave programs, can increase when you elect S Corp taxation. However, these are generally minor compared to the reduction in Social Security and Medicare taxes at higher business income levels.

As mentioned earlier, S corporations are pass-through entities and generally do not pay federal income tax directly, although there are some exceptions and various states impose their own business, franchise or entity-level taxes. Shareholders pay Social Security and Medicare taxes on their salaries, but not on the remaining ordinary business income that flows through on the K-1.

Therefore, you would want a tiny salary and a large distribution, right? Easy math. Well, sure, but there is a small little IRS rule called “reasonable shareholder salaries” that we spend an entire chapter on.

We’ll also show in a later chapter that S corporations have various sweet spots in terms of income versus payroll tax savings, from around $30,000 to $2 million, when comparing sole proprietorships, LLCs, partnerships and entities taxed as an S corporation. The answer changes based on salary, other W-2 income, Section 199A, state taxes and the cost of running the S Corp, so there is some math involved. Shocking, we know.

Is an S Corp an LLC?

Contrary to popular belief, S corporation status is not formed. It is elected.

You first have an underlying entity, commonly a limited liability company or corporation, and then elect to have that entity taxed as an S corporation on Form 2553. In the case of an eligible LLC, the check-the-box regulations treat the S Corp election as also making the necessary corporate tax classification election.

One form, two elections. Neat.

After the election, you are treated as an S corporation for federal tax purposes. The underlying state-law entity does not change!

A lot of business owners rightfully say, “I have an LLC taxed as an S Corp,” but they also say, “I have an S Corp.” Technically the former is more accurate, but both get the point across.

This creates some weird accounting terminology. If the underlying entity is an LLC, it does not suddenly issue stock simply because it elected S Corp taxation. LLCs have membership interests, not shares of corporate stock.

At WCG, our current thinking is to keep the accounting records consistent with the underlying legal entity while still allowing the books to map cleanly to Form 1120S. If you contribute $10,000 of seed money to your LLC taxed as an S Corp, the journal entry might simply be-

DR Cash $10,000
CR Additional Paid-In Capital $10,000

You could also use a Member Contributions or Contributed Capital account in the accounting records and map that account to Additional Paid-In Capital on the S corporation tax return.

What we generally would not do for an LLC is create a Capital Stock account merely because Form 1120S uses corporate terminology. There is no actual stock if the underlying legal entity is an LLC. If the underlying entity is an actual corporation that issued shares, Capital Stock is appropriate. Different animal.

One more warning: do not confuse book equity with shareholder basis.

A $10,000 cash contribution will generally increase both book equity and the shareholder’s stock basis by $10,000 on day one, but those numbers can quickly diverge. Shareholder basis is a separate tax calculation that moves with items such as-

• Capital contributions
• Business income and separately stated income
• Losses and deductions
• Nondeductible expenses
• Shareholder distributions
• Loans you personally make to the S Corp (debt basis), but not loans you merely guarantee (Treas. Reg. 1.1366-2(a)(2))

Book equity tells you what is happening inside the entity’s accounting records. Shareholder basis tells you, among other things, whether losses are deductible and whether distributions are tax-free. They are cousins, not twins. The IRS cares enough about this that shareholders must attach Form 7203 to their individual tax return to show their basis calculation in any year they claim a loss, receive a distribution, sell stock or get a loan repaid.

This is another example of the weird limbo created by an S Corp election. You need to walk and talk like a corporation for federal taxation, but the underlying entity and what the Secretary of State has on file might still be a limited liability company. Taxation changed. Governance did not.

More on the election mechanics and behind-the-scenes stuff in a later chapter, plus our thoughts on corporate governance, Meetings and Minutes, shareholder basis and all the other wonderfully exciting things you bought this book for.

Again, this book is mostly about S Corps. The last couple of pages were a slamma-jamma description of the basics.