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The advantage of an S corporation over a C corporation is the flow-through nature of the entity. (Know that an LLC can also be a flow-through entity and that an LP must be taxed in such a manner.) Profits are taxed not at the entity level but rather at the shareholder level.

For startup businesses that expect to incur losses early, an S corporation may be a better entity choice than the C corporation. S corporation shareholders are able to deduct a share of those losses on their personal income tax returns to the extent of the number of shares they own and to the extent of the amount of any loans they have made to the business. C corporation shareholders aren’t allowed to take these deductions. Then again, the C corporation (but not the shareholders) can use their losses to offset future gains.

In an S corporation, once the business begins making a profit, those profits are taxed as income to shareholders at their individual tax rate, even if the profits are not distributed. So if your one person company has a profit of $50,000 at the end of the year and you need that money in the company for next year’s expansion you’ll pay tax on a $50,000 gain. (One solution may be to flow through enough money to pay the taxes. So if your tax rate is 28% you’d distribute $14,000 from the Company to you to pay the 28% tax on a $50,000 profit.) Know that S corporation income is reported on your individual return.

A key advantage of the S corporation has to do with Social Security withholding taxes. (In some situations they are called FICA taxes, in others self-employment taxes. We will generally refer to these monies headed to our bankrupt Social Security system as ‘payroll taxes’.) Shareholders in an S corporation who take a salary can also take distribution of excess profits without paying payroll taxes. However, the salary the shareholder receives must be reasonable. Too low a salary coupled with higher distributions of profits can signal to the IRS that a shareholder is avoiding paying the Social Security system its ‘fair’ share and trigger an audit. If the discrepancy between the low salary and the high amount of distributions is too great, the IRS may disallow the distribution and consider all monies received to be salary, with taxes to be owed on that amount (along with penalties and interest).

The chart below helps to explain the concept. In example A, the owner pays herself a very low salary of $10,000 and thus only pays payroll taxes of $1,530. The company makes a profit of $1,000,000 and while the owner will pay regular income taxes on the flow through distribution she won’t pay any payroll taxes on that amount.

The IRS will make a very reasonable argument when reviewing this case: Could you hire someone else to run your business for $10,000 a year to make you a million dollar profit? Of course, the answer is no.

Which is why Example B is closer to the economic and market reality of the transaction. In today’s market you would more likely have to pay someone at least $100,000 a year to manage a business that now produced $900,000 in annual profits. Notice the difference for the Social Security system. Instead of just $1,530 a year Social Security gets $15,300 a year. They want that money. They need that money.

So be careful on what you take for a salary. Don’t make it too low, or too high. You just need to be on the cheaper side of reasonable. There is a website called salary.com which offers comparisons for salary levels in various industries. And work with your CPA to arrive at a reasonable salary amount.