Should your business be an S-Corporation?

S-Corporations are one of the most commonly recommended forms for new business owners to save taxes, however; it’s important not to rush into structuring your business as an s-corporation as you may not realize these benefits until your business reaches significant profitability. You should weigh the tax savings of having an s-corporation with the additional costs associated with the business.

Tax Savings

The S-Corporation structure allows business owners to avoid self-employment taxes on the net income from their businesses.

What are Self-Employment taxes? These are Social Security & Medicare taxes on the net income of self-employed individuals. These same taxes, at the same rates, apply to employees’ wages but with some important differences. With employees, the employer withholds the employee share of Social Security tax (6.2%) and Medicare tax (1.45%) of the employees wages and pays the employer share of these same taxes at the same rates on the employees’ wages. Self-employed individuals, on the other hand, pay both the employee share and employer share on the net income of their businesses. This adds up to a significant amount, 15.3% of the net income from their businesses. Further, these taxes are in addition to income taxes on this income.

Understandably, if you can avoid giving up 15.3% of your net income it would be a no-brainer to do it. However, you shouldn’t rush into structuring your business as an s-corporation as there are additional costs associated with having an s-corporation. You should make sure the tax savings of the s-corporation structure outweigh the additional costs.

There is a limit on Social Security taxes that apply to employees’ wages as well and self employed individuals’ net income. The wage limit for 2021 is $142,800. This means the 12.4% tax savings on Social Security taxes included in self-employment taxes only applies on net income up to this amount. As discussed in more detail later, s-corporation owners are required to pay themselves wages for services performed in their s-corporations that will be subject to payroll taxes including Social Security and Medicare taxes, further reducing the tax savings.

Costs of S-Corporations

Increased tax preparation Fees: Having an s-corporation makes your tax situation more complex compared to sole proprietorships. With a sole proprietorship, the activity for your business is reported directly on your personal tax return on a Schedule C. With an s-corporation, your business is required to file an s-corporation tax return, separate from your personal tax return. This will result in additional tax prep fees and cost to meet compliance.

State formation and annual registration fees: An S-Corporation requires you to have either an LLC or a corporation that elects to be taxed as an s-corporation with the IRS. This means additional costs in fees paid to your state to form the business as well as annual fees your state charges in order for your business to stay registered with your state. Additionally, aspiring business owners often pay professionals to help them with forming their business and obtaining tax ID numbers, payroll accounts, and other registrations for their future businesses as it’s typically less costly to do things correctly the first time around.

Payroll Costs: owners of s-corporations are required to be paid wages for services they perform in their businesses. This requires using a payroll service to file payroll reports and making payroll tax payments for the s-corporation.

What if my business has a loss?

Many new businesses are not profitable their first year in business. If there is no net income, there are no self-employment taxes that would be due. The additional costs of having an s-corporation compared to a sole proprietorship can weigh heavy on new business owner struggling to grow their business and make ends meet.

Compliance Requirements of S-Corporations

Owners that perform services in their s-corporations are required to pay themselves a reasonable salary for the services they perform in the business. A good rule of thumb to use for determining how much of a salary is reasonable is to ask, “How much would I have to pay someone with the necessary experience to perform the services I perform in my business?” You should take into account the same factors that would apply to compensating any employee, such as educational background, professional experience, hours, and cost of living for your area.

Is an S-Corporation Owner able to Limit their Wages to the Net Income of the Business?

Yes, you’re not required to create a loss in your business just to pay yourself enough wages to meet the compliance requirement of paying yourself a reasonable salary.

When to Treat Your Business as an S-Corporation

As you may expect, you should make the switch when the tax savings of the s-corporation structure outweighs any costs of having the s-corporation. This means waiting until a level of profitability from your business in excess of the reasonable salary you would be required to pay yourself for services you perform in your business.

Planning the Switch to Treat Your Business as an S-Corporation

You can start with a different business structure, such as a sole proprietorship, and make the decision to form an LLC or corporation in a later year, when the business reaches a level of profitability that makes sense for the business to be treated as an s-corporation.

By default, an LLC that has only one owner is treated as a sole proprietorship for tax purposes until electing to be an s-corporation. This can result in a number of advantages; you won’t be required form a new entity later on when you decide to make the switch to an s-corporation, you’ll start with a business structure that may offer limited legal liability in the case of legal issues, and it keeps your tax returns simple and associated tax prep fees down since the activity is reported directly on your personal tax return until making the switch to be an s-corporation.

Contact me to discuss this topic in further detail

Please note: the information on this website is intended to provide general advice to start the discussion with your tax professional. The information on this website may not apply to your specific situation. Only an experienced professional with the details of your specific situation can advise you on making the best decision. Contact me or your tax professional to discuss the information on this site to make an informed decision.