The S-Corporation Election

The first real tax structure is the S-corporation. It is not a different kind of company — it is a tax election, made on Form 2553, available to an LLC or a corporation that meets the eligibility rules. Its purpose is narrow and powerful: it splits the owner’s income into two streams that the payroll-tax system treats differently.

W-2 salary

The owner is an employee of their own company and draws a salary, subject to the same 15.3% in Social Security and Medicare taxes — now split, on paper, between the employee and the corporation.

Shareholder distributions

Profit beyond the salary is distributed to the owner as a return on the business. Distributions carry no self-employment or payroll tax.

The distribution stream is where the saving lives. Every dollar moved from salary to distribution escapes the 2.9% Medicare tax, and — to the extent salary stays below the Social Security wage base — the 12.4% Social Security tax as well. There is no equivalent move available to a sole proprietor.

The split also clears the other 3.8%. For an owner who materially participates, S-corporation distributions are outside net investment income under IRC §1411(c)(2), “Imposition of tax”, so they carry neither self-employment tax nor the net investment income tax (NIIT) — the only category of income in the code subject to neither. A general partner’s active share pays self-employment tax; a passive owner’s share of either entity pays NIIT. Only the active S-corporation distribution pays nothing, which is the whole reason the reasonable-compensation fight exists.

Eligibility restrictions. S-corporation status is not available to every business. The corporation may have no more than 100 shareholders, all of whom must be US citizens or resident aliens (not nonresident aliens), individuals, certain trusts (the ESBT and QSST of section “Trusts That Hold S Corporation Stock: ESBTs and QSSTs”), or estates — partnerships, multi-member LLCs, C-corporations, and most foreign owners are ineligible shareholders. The corporation may have only one class of stock, though differences in voting rights are permitted. A founder with a non-citizen spouse holding the stock as community property should verify the spouse’s residency status before electing; a founder planning to bring on a VC or a family trust should verify trust eligibility before signing. A single ineligible shareholder on a single day terminates the S election, with no automatic relief.