Hidden Advantages of Using an S Corporation

The big, well-known advantage of an S corporation concerns payroll taxes. Simply stated, while working partners and sole proprietors pay self-employment taxes on all of the business profit, S corporation shareholders pay employment taxes only on that portion of the business profit designated wages.

This payroll tax savings angle is big. And traditionally this benefit is the one business owners and professional advisors highlight. But the S corporation election also delivers several small, more subtle advantages, according to many knowledgable CPAs.

Less Audit Risk for an S Corporation

Here's a first, simple and almost secret tax advantage to using an S corporation rather than a sole proprietorship. Quite possibly, with an S corporation you reduce your audit risk. The argument here is a tiny bit kooky...but in a nutshell sole proprietorship tax returns (the Schedule C form which goes inside the proprietor's 1040 return) are notoriously inaccurate and mistake-laden. Off the record, you'll hear IRS auditors and tax accountants say that as compared to sole proprietorships, the S corp return gets less attention from the examiners.

Easier Basis Calculations for an S Corporation

Another accounting benefit of using an S corporation concerns how basis calculations work. Simply stated, an S corporation shareholder's basis is easier to calculate than a partner's basis in a partnership or than an LLC member's interest in an LLC treated as a partnership.

The accounting for basis quickly gets complicated with partnerships and limited liability companies treated as partnerships. But to summarize, these entities use complicated rules to assign chunks of the loans to the partnership or LLC to partners or members as basis.

In a way, that bonus basis is great. If a partnership or an LLC taxed as a partnership loses money, partners can deduct losses to the extend they have basis. But the complicated basis calculations related to partnership or LLC liabilities makes it easy for a small business or its accountants to screw up the basis calculations.

With an S corporation, in comparison, basis calculations work very simply. Shareholders get basis for money they've invested or reinvested in the business. And shareholders get basis for money they've loaned the business. Period. This simpler basis calculation process means that the S corp stockholder will regularly get less credit for "basis" as compared to a partner or an LLC member. But the simplicity probably reduces accounting mistakes and unintentional tax return errors.

Moves Some Deductions onto Business Tax Return

One other quick point about S corporations as compared to sole proprietorships and partnerships: With an S corporation, you may find that you get new and more valuable business tax deductions.

But let me explain. Any necessary and ordinary expenditure of a business is, barring some rule that says otherwise, a tax deduction. Typically, the type of entity--partnership, proprietorship, corporation and so forth--doesn't have effect on the tax deductibility.

However, the entity choice may affect WHERE a deduction is reported. And the location where the deduction is reported can affect the tax savings you receive. To give you a couple of examples, both pension contributions and self-employed health insurance premiums can be deducted on sole proprietorship tax returns, partner returns, and S corporation returns. In other words, the owners of all of these entities get tax deductions for pensions and health insurance (if the rules are followed).

But with sole proprietorships and partners in partnerships, these deductions get reported on the proprietor's or partner's individual tax return as adjustments for gross income. This accounting treatment still gets you the income tax deduction. But things work differently and better with an S corporation... With an S corporation, these deductions go on the S corporation 1120S tax return as business expenses. And that means that the deductions reduce both income taxes AND employment taxes.

Seattle tax accountant Stephen Nelson is the author of numerous books about small business accounting, probably including one or two that sit on your credenza if you use either Quicken or QuickBooks. Nelson is also the author of an S corporation frequent asked questions page and the owner of a incorporation services firm that specializes in S corporation setup services.

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