If you’re like me, YouTube is the preferred go-to source for information. It contains a plethora of videos on any topic you can imagine. I was recently watching a bunch of videos from tax and accounting gurus regarding S-Corps. While the information was valid, I wound up having concerns about the information that was being left out.
Let’s take a deeper dive.
So what is this almighty S-Corp that everyone keeps propping up?
An S-Corp (Subchapter S Corporation) is a tax designation with the Internal Revenue Service (IRS). Many think S-Corps are entities in themselves, but they’re simply a tax status with the IRS. S-Corps are considered “pass-through” entities, meaning that all profits or losses are passed through to the owners and reported on their personal income tax returns.
Not every business qualifies for S-Corp status. To be eligible, your business must meet a few IRS requirements — no more than 100 shareholders, only one class of stock, and all shareholders must be U.S. citizens or residents. For most small business owners and founders, this won’t be an issue. But it’s worth noting before you assume the election is available to you.
The election is made by filing Form 2553 with the IRS. For the election to take effect in the current tax year, it must be filed by March 15. Miss that deadline and you’ll be waiting until the following year.
Why are S-Corps so highly recommended?
The S-Corp has become something of a default position. If you hired an accountant early on in your business venture, there is a good chance they told you to elect S-Corp status without providing all of the nuances involved. I know because that happened to me when I started my first business. The accountant said to elect S-Corp status. I did not fully understand why at the time, and I just assumed it was the right call.
To be fair, there are real advantages — and I will get to those. But I think a lot of founders adopt the S-Corp because they hear it sounds smart, not because they have actually thought through whether it makes sense for where they are in their business.
First, let’s cover the benefits of an S-Corp.
Since S-Corps are pass-through entities, the business is not taxed at the corporate level. In contrast, a C-Corp (Corporation) is taxed at both the corporate level, at 21%, and at the owner level. S-Corps avoid the double taxation, which inevitably translates to more money in your pocket.
The IRS also requires S-Corp shareholders to take a “reasonable salary” if they perform any meaningful services for the business. The IRS doesn’t clearly define reasonable salary, but the general standard is this — what would you pay someone else with your experience to do the work you perform?
However, the “main” benefit of an S-Corp relates to what’s called “owner distributions”. Any profit above general expenses, including salaries, may be paid to the owners as distributions, as opposed to salary.
A salary is subject to both your federal income tax rate and self-employment taxes, which equal 15.3%, and cover Social Security and Medicare. This applies to net earnings of $400 or more. Owner distributions, on the other hand, are only taxed at your federal income tax rate — and are not subject to self-employment taxes.
Let’s look at a simple example:
Susie owns a lawn care business. Her net revenue is $200,000 per year. Her yearly general expenses equal $75,000, leaving her with $125,000. She pays herself a reasonable salary of $70,000, which leaves $55,000. She will pay self-employment taxes on the $70,000 salary. But she takes the remaining $55,000 as an owner’s distribution. If she had taken that $55,000 as additional salary, she would owe $8,415 ($55,000 x .153) in self-employment taxes. By taking it as a distribution instead, she keeps that $8,415 in her pocket.
As illustrated above, the tax savings can be significant. So, the hype is real. There’s no denying it. I think every business owner would jump on the opportunity to keep thousands of dollars in their pocket.
So, what’s the downside?
When you elect S-Corp status, your business is required to file its own tax return. The business isn’t taxed at the corporate level, but the IRS still requires a separate return — Form 1120-S — and the business will issue a Schedule K-1 to each owner, who then reports that information on their personal tax return. That’s an added cost that a standard LLC or sole proprietor doesn’t have. With a regular LLC and no S-Corp election, you simply file a Schedule C with your personal 1040. No separate business return required.
Another cost to consider is payroll. S-Corps are required to run payroll for a reasonable salary, which typically means hiring an accountant or using a service like QuickBooks or ADP. With a standard LLC and no S-Corp election, that step isn’t required — money can flow directly from your business to your bank account.
If you’re not able to reap the benefits of an S-Corp, you’re likely just spending extra money.
Here’s my honest take.
If you have recently started a business and are trying to keep your costs lean, the S-Corp may not be the right move yet. The added expenses of payroll services, a separate business tax return, and the accounting complexity are not worth the money, in my opinion. The question you should be asking is not “should I elect S-Corp status?” but rather “where is my business right now, and do the tax savings outweigh what I am going to spend to maintain this structure?”
A good rule of thumb — if you are not generating at least $20,000 – $50,000 in net profit, the S-Corp election may not be worth it yet. While an S-Corp can be a great strategy, timing matters. Electing it too early, before your business can absorb those added costs, may end up costing you more than it saves.
One more thing worth noting — once you elect S-Corp status, changing your mind isn’t easy. The IRS generally requires a five-year waiting period before you can re-elect S-Corp status, though exceptions do exist in certain circumstances.
Taxes and tax law are complicated. That’s why they have specialists who handle these things. But educating yourself so you have a baseline knowledge will equip you to ask the appropriate questions of your accountant.
*This is not intended to be tax advice and is for general information purposes only.