The “S” comes from a filing that the corporation or LLC submits to the IRS under Subchapter S of the Tax Code. This does change some of the rules of the business entity so make sure you check with an attorney before filing for it. NOT ALL LLCs AND CORPORATIONS QUALIFY! It does, however, provide some tax benefits when the owners file their taxes.
First, the S-Entity files its own tax return. It doesn’t pay any taxes, it just files the return indicating how the profits were divided among the owners. The owners then claim those profits on their personal tax return as income. Without filing the form with the IRS for the “S” status, those profits would be taxed as Self-Employment (SE) Income and it’s subject to the self employment tax (SE tax) which is about 15% (for more information, see Taxes). This is not income tax! It is a salary tax. This is essentially the FICA and medicare tax that comes out of your paycheck if you had an employer. This is the tax where you paid half and your employer paid half. But since you are the employer and the employed, you pay BOTH parts.
By filing under Subchapter S, you can decide how to take out the profits. You can take part out as “salary” which is, as above, subject to the SE tax and part out as “dividends” which is not subject to the SE tax (because it is a dividend or return on investment and not income). So, you can save approximately 15% on the part of the profits you claim as “dividends.”
THERE ARE RULES REGARDING HOW YOU TAKE OUT THE PROFITS. THE IRS REQUIRES THAT YOU PAY YOURSELF A REASONABLE SALARY, SO YOU CANNOT TAKE IT ALL OUT AS DIVIDENDS. THERE ARE ALSO RULES ABOUT WHO CAN BE AN OWNER OF AN S-ENTITY. ALSO NOTE THAT YOU WILL STILL OWE INCOME TAXES (FEDERAL AND STATE) AS THOSE ARE CALCULATED SEPARATELY FROM THE SE TAX.
THIS INFORMATION IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL OR TAX ADVICE. PLEASE CONSULT AN ATTORNEY AND TAX ACCOUNTANT BEFORE MAKING ANY TAX ELECTIONS.