As your business becomes more profitable, you may begin hearing that you should form an S corporation. Friends, colleagues, or other business owners may say that an S corporation will automatically lower your taxes. While an S corporation can produce meaningful tax savings in the right circumstances, it is not the best choice for every business.
The decision depends on several factors, including your net business profit, the type of work you perform, the salary you would need to pay yourself, your state’s tax rules, and the cost of maintaining the corporation.
Before making an election, it is important to understand both the potential benefits and the additional responsibilities.
What Is an S Corporation?
An S corporation is primarily a tax classification. A corporation or an eligible limited liability company may elect to be taxed as an S corporation by filing the appropriate election with the IRS. An S corporation is generally treated as a pass-through business. This means the business itself usually does not pay federal income tax. Instead, its income, deductions, and other tax items pass through to the owners. Each owner reports their share of the business activity on their individual tax return.
The business must also file a separate S corporation tax return each year. The owners receive Schedule K-1 forms showing their share of the corporation’s taxable income or loss.
Forming an LLC or corporation with your state does not automatically make the business an S corporation. The business must make a separate federal tax election.
How Can an S Corporation Save Taxes?
The primary potential benefit of an S corporation is a reduction in employment taxes. A sole proprietor generally pays self-employment tax on the business’s net earnings.
An owner who works for an S corporation typically receives money from the business in two ways:
- A salary paid through payroll
- Shareholder distributions from the remaining profit
The owner’s salary is subject to Social Security and Medicare payroll taxes. Properly classified shareholder distributions are generally not subject to those employment taxes. This difference may produce tax savings when the business earns significantly more than the reasonable salary paid to the owner.
For example, suppose a business earns $140,000 before paying its owner. If a reasonable salary for the owner’s work is $90,000, the owner may be able to receive $90,000 through payroll and some of the remaining profit as a distribution. Payroll taxes generally apply to the salary but not to the distribution.
However, the distribution is not tax-free. The owner will generally pay federal and state income tax on their share of the corporation’s taxable profit. An owner can also owe income tax on business profit even when some of the money remains in the business bank account.
You Must Pay Yourself a Reasonable Salary
An owner cannot avoid payroll taxes by taking all the company’s money as distributions. If an owner performs services for the corporation, the IRS generally requires the business to pay that owner reasonable compensation before making non-wage distributions. There is no single percentage or formula that establishes a reasonable salary.
Factors may include:
- The owner’s duties and responsibilities
- Education, experience, and professional qualifications
- The number of hours worked
- Salaries paid for comparable positions
- The company’s location and industry
- The amount of revenue produced by the owner’s work
- The business’s size and profitability
The type of business is especially important. If nearly all the company’s revenue is generated by the owner’s personal services, a substantial portion of the profit may need to be treated as wages.
For example, a consultant, designer, photographer, tax professional, or other service provider may personally generate most of the business revenue. In that situation, paying a very low salary while taking large distributions could be difficult to support.
If the IRS determines that a salary was unreasonably low, it may reclassify distributions as wages. The business and owner could then owe additional payroll taxes, penalties, and interest.
How Much Profit Makes an S Corporation Worthwhile?
There is no universal income level at which a business should become an S corporation. Gross revenue alone does not provide the answer. The more important number is the business’s net profit after deductible expenses. An S corporation is generally more attractive when the business has stable profit that is meaningfully higher than a reasonable salary for the owner.
Suppose a business earns $60,000 before paying its owner, and a reasonable salary for the owner’s work would be approximately $55,000. There may not be enough profit remaining to create meaningful tax savings after paying for payroll, bookkeeping, tax preparation, and state fees. If the business earns $160,000 and a reasonable salary is approximately $90,000, there may be more opportunity for tax savings. Even then, the numbers should be calculated carefully before making the election.
Instead of relying on a general income threshold, ask a tax professional to compare:
- Your expected net business profit
- A reasonable salary for your work
- Payroll and employment taxes
- State corporate taxes and fees
- Payroll service costs
- Bookkeeping and tax-preparation fees
- The estimated tax savings from distributions
This comparison will show whether the potential savings are likely to outweigh the additional costs.
What Are the Additional Responsibilities?
An S corporation requires more administration than a sole proprietorship. The owner must treat the corporation as a separate business and maintain reliable financial records.
The corporation will generally need to:
- Operate payroll
- Issue the owner a Form W-2
- File quarterly and annual payroll tax returns
- Make payroll tax deposits
- File a separate S corporation income tax return
- Maintain accurate bookkeeping
- Keep business and personal expenses separate
- Complete required federal and state filings
The owner may also need workers’ compensation insurance, state payroll accounts, unemployment insurance accounts, corporate records, and local business licenses. Late payroll deposits and tax returns may result in penalties. For this reason, an S corporation is usually most practical for an owner who is prepared to maintain current bookkeeping and run payroll consistently.
California S Corporation Taxes
California business owners must also consider state taxes. California generally imposes a tax of 1.5% on an S corporation’s California net income. An $800 minimum franchise tax may also apply, depending on the entity and its circumstances. These state taxes reduce some of the federal employment-tax benefit. They do not necessarily eliminate the savings, but they must be included when comparing business structures.
California businesses may also have additional costs for payroll, entity registration, annual filings, local permits, and professional services.
Other Potential Benefits
An S corporation may offer benefits beyond employment-tax savings. Paying yourself through payroll creates a formal record of wages, which may be useful when applying for a mortgage or other financing. An S corporation may also make the business feel more structured as it begins hiring employees or expanding its operations.
The corporation may pay or reimburse certain health insurance premiums for an owner who owns more than 2% of the business. However, special reporting rules apply. The premiums may need to be included on the owner’s Form W-2 for the owner to qualify for a personal health insurance deduction.
An S corporation may also establish a retirement plan. However, retirement contributions are generally based on the owner’s W-2 compensation rather than shareholder distributions. Paying a lower salary could therefore reduce the amount the owner can contribute to certain retirement plans.
Possible Disadvantages
The S corporation structure is not always the right choice.
Potential disadvantages include:
- Higher tax-preparation and bookkeeping costs
- Payroll filing requirements
- State corporate taxes and fees
- Penalties for missed filings or payroll deposits
- Reasonable-salary requirements
- More complicated health insurance and benefit rules
- Restrictions on ownership
- Less flexibility when dividing profits among multiple owners
Business income may also fluctuate from year to year. A company may have enough profit to justify the election in one year but not the next. Because the administrative responsibilities continue, it is helpful to look at the business’s expected long-term income rather than relying on one unusually profitable year.
When Must the Election Be Made?
A business generally files Form 2553 to elect S corporation tax treatment. For an existing calendar-year business that wants the election effective January 1, the usual deadline is March 15 of that year. A business may also make the election during the preceding year. If the regular deadline is missed, late-election relief may be available when the business meets the IRS requirements and has reasonable cause for filing late.
The effective date matters. Business owners should not begin treating payments as S corporation wages or distributions until the entity, election date, bookkeeping, and payroll have been properly established.
Is an S Corporation Right for You?
An S corporation may be beneficial when your business has consistent profit above a reasonable salary and the potential employment-tax savings exceed the additional expenses. It may not be worthwhile when your profit is low or unpredictable, when nearly all the profit must be paid as reasonable compensation, or when you are not prepared to maintain payroll and current financial records.
Before making the election, have a tax professional prepare a personalized comparison. The analysis should account for your income, expenses, reasonable salary, payroll costs, state taxes, health insurance, retirement goals, and professional fees.
An S corporation can be a useful tax-planning strategy, but it should be based on actual numbers, not a general recommendation or a rule of thumb. Contact MP Tax Group to discuss your projected business income and determine whether an S corporation may be appropriate for you.
Disclosure: This article is provided for general informational and educational purposes only. It is not intended as tax, legal, payroll, or financial advice. S corporation eligibility, tax savings, reasonable compensation, filing requirements, and state obligations depend on each taxpayer’s circumstances. Tax laws may change. Consult a qualified tax and legal professional before forming a business entity, making an S corporation election, starting payroll, or taking shareholder distributions.