S corporation

Given these differences in tax advantages of S corporation, LLC and partnership, you might think that the owners of a regular corporation who wish to receive pass through taxation of business income should dissolve the corporation and form an LLC or partnership, rather than electing S corporation tax treatment.

The alternative of electing S corporation tax treatment

The owner of a corporation rarely dissolves the corporation. Instead, the owner of a corporation wants to receive pass through taxation, he or she often elect S corporation tax treatment. Why? This is because the type of conversion (from a corporation to an LLC or partnership) is expensive in terms of taxes and legal fees. In other words, it’s normally best for an existing corporation to elect S corporation tax status if it wants pass through tax treatment, even if the S corporation election does not provide full pass through tax benefits. This is a complex tax issue and you should check with a tax adviser or tax attorney if you are considering incorporating an S corporation.

Advantages of S corporation

S corporation status can reduce self employment taxes. There is one area where S corporations currently do better than LLCs or partnerships. That is in the area of self employment taxes. Although the current federal tax rules are not specifically written for LLC, tax experts generally advise their clients that LLC managing owners and managing partners must pay self employment taxes on their share of business profits. The self employment tax bite can be hefty such as over 15% of taxable income.

The owners of an S corporation pay self employment taxes only on compensation (salaries and bonuses) paid to them, not on profits automatically allocated to them as a shareholder. To take advantage of this benefit, some corporate
owners elect S corporation tax treatment, then pay themselves a low salary. Hence the remaining S corporation profits (which are automatically allocated to the shareholders) are not subject to self employment tax. This is an ggressive
tax strategy, and the IRS may challenge S corporation owners who lower their salaries below a reasonable level simply to avoid self employment taxes.