what you need to know before opening an S-corp
And, why you shouldn’t open one without an accountant
Read time: 15 min
People on the internet love recommending S-corps. Well-meaning commenters, poorly researched blog posts, and irresponsible accountants all advocate for forming an S-corp to save taxes. They tell you it will save you thousands! And, that great (who wouldn’t want to save thousands). But, they often leave out the realities that come along with becoming an S-corp.
- The well-meaning commenters are repeating an oversimplified explanation their accountant gave them before tax reform (which obviously changed things) that applied to their specific finances and business.
- The poorly researched blog posts are repeating other incorrect blog posts that never seem to quote IRS publications.
- And lastly, irresponsible accountants claim S-corps will save you huge sums of money so you’ll call in for their help. Maybe you’ve even seen their Facebook ads, “the one entity accountants don’t want you to know about to save you $16,000” (hint: it’s an S-corp).
All these sources leave out many of the realities of becoming an S-corp. There are additional costs, complexities, and, in some cases, you may even wind up paying more tax or, after administrative costs, barely breaking even. But, that doesn’t make for a sexy blog post.
Table of Contents
In this course, you’ll learn:
- sole proprietorship vs LLC vs S-corp
- how much do you have to pay the owner?
- other reasonable compensation considerations
- what if you pay the owner $0 to minimize their employer taxes?
- focus on the net savings, not the tax savings
- running payroll and filing taxes costs money
- QBI deduction is based on profit
- local tax issues
Consider this blog post ‘S-corporations 101.’ You won’t learn enough to do your own taxes or decide if an S-corp is right for you. But, you will learn enough to hold your own during tax talk at a networking event.
part i: how S-corps save money
sole proprietorship vs LLC vs S-corp
Before you can understand how S-corps save money, you need to understand all your options. And, for that, we need to have a fun, fun conversation about taxes.
Usually, when you first start your business, it’s a sole proprietorship which means it’s an unincorporated business with no legal entity. You might have applied for some local business licenses or a tax ID number, but you don’t have a legal entity formed with the State.
The revenue and expenses from sole proprietorships are reported on Schedule C of your personal tax return. The profit from these businesses is both income taxed and self-employment taxed. Self-employment tax is essentially the same thing as FICA taxes or employer taxes. It’s comprised of Social Security and Medicare taxes.
Currently (2021), self-employment tax is 15.3% of profit until you hit the $142,800 Social Security wage cap then 2.9% of any remaining profit. You’re allowed to take a deduction for half the self-employment tax you pay, but even with the deduction, self-employment tax can add up to be a lot of money.
LLCs and partnerships:
Alternatively, some entrepreneurs will immediately form an Limited Liability Company (COMPANY, not a Limited Liability Corporation) when starting their business. LLCs are state-level entities (aka you form them with your state’s Department of Corporations) that can elect one of multiple tax statuses. Initially, single member LLCs (also called, SMLLCs) are considered disregarded entities (eg don’t exist for tax purposes) and are taxed just like sole proprietorships. Yes, you read that right. Single member LLCs are taxed exactly like sole proprietorships.
If the LLC has multiple members, it is initially taxed like a partnership. Partnerships have their own separate tax return then pass each partners’ share of profit down to them to be taxed on their personal tax return. Partners pay both income and self-employment tax on all of this profit.
The tax problem with sole proprietorships, single member LLC, and partnerships is that they pay self-employment tax on their entire profit. That can add up to be quite a bit of money. S-corps are generally used to solve the self-employment tax problem.
S-corporations are formed by first creating an LLC or C-corporation then making the S-election. This election is made by filing paperwork with the IRS (and, in some states, with the state) and can be made immediately or later on when it makes sense for the business.
S-corps pass their profit down to the owner’s to be taxed on their personal tax return. The owner’s pay income tax on their entire share of the profit. There’s no getting around income tax. But, they don’t pay self-employment tax on the entire profit like sole proprietorships, single member LLCs, and partnerships.
S-corps are only required to pay employer tax (remember, it’s the same thing as self-employment tax) on the reasonable salary they pay the owner. Any remaining profit, after paying the salary, is only income taxed. And, therein lies the magic of S-corps. S-corps save money by minimizing self-employment tax. And, the self-employment tax savings depends on the owner’s salary and the S-corp’s remaining profit. But, like with all things tax, it’s not that simple.
how much do you have to pay the owner?
Sole proprietorship, single member LLC, and partnership, owners are “paid” with the business profits. They aren’t on payroll or given a paycheck. S-corp owners are paid a salary. The question is, how much should they be paid? And, there’s really no good answer.
The IRS calls this owner salary “reasonable compensation,” but never gave an exact definition for how much it should be. They just said the owner has to be paid reasonable compensation for their services as an employee of the business. They don’t provide a framework. The only existing guidance comes from Tax Court cases where someone paid themselves too little and lost.
Accountants often disagree on what reasonable compensation means. Some accountants believe there’s a reasonable compensation ratio. That 40%-60% of profit should be recategorized as salary and the rest should be profit. But, the ratio has never stood up in a reasonable compensation audit.
Other accountants (including myself) think reasonable compensation should be based on real-world data and real-world salaries. To oversimplify a complex issue, you should pay yourself how much it would cost to replace yourself aka how much you would reasonably compensate someone to do what you do. There are a few different ways to determine how much that is. Some accountants just look up wage data on Payscale, LinkedIn, or some other salary website. I use a wage database to create annual reasonable compensation reports for all my S-corp clients. That gives us a good, solid answer and, if they’re ever audited, we’ll have proof that we made an educated decision instead of just winging it (#HireMe 😉).
other reasonable compensation considerations
On top of all that, you also need to consider local laws (can’t pay the owner less than minimum wage!) and how much of the overall profit is generated by the owner.
According to the IRS, the three main sources of gross receipts (revenue) are:
- Services of shareholder
- Services of non-shareholder employees or
- Capital and equipment
And, “to the extent gross receipts are generated by the shareholder’s personal services, then payments to the shareholder-employee should be classified as wages that are subject to employment taxes.” That’s a direct quote from the IRS. Check it: here
That means, regardless of what you’d pay someone to perform your role, if you run a service business (eg your business doesn’t rely on merch, capital, or equipment) and you’re the only person working in the business, your entire profit should be reasonable compensation.
(That wasn’t always the case because the quoted section wasn’t always a part of IRS guidance. In the past, many accountants recomended S-corps to single owner-employee businesses as a way to save taxes. But, now that guidance has changed, I don’t recommend S-corps to single owner-employee businesses, even though many accountants still are.)
what if you pay the owner $0 to minimize their employer taxes?
You don’t need IRS approval for your reasonable compensation. You could set it to whatever you want, including $0 per year, and call that your reasonable compensation.
Many accountants (and DIY entrepreneurs) do just that and set reasonable compensation unreasonably low to maximize the tax benefit of S-corps. By setting the owner’s reasonable compensation unreasonably low, they’ll only pay self-employment tax on the artificially low salary thereby saving even more money.
These intentionally and fraudulently low salaries are illegal. As an owner-employee of an S-corp you’re required to pay reasonable compensation. We can argue about what exactlyyy reasonable means (eg is $90,000 okay when the fair market salary is $95,000?). But, I think you KNOW what’s totally unreasonable. (eg $25,000 salaries when the fair market salary is $95,000)
There’s two main problems with fraudulently low salaries. The first problem is the ‘reasonable compensation audit’. These audits are trigged during regular IRS reasonable compensation reviews where they check what’s listed on your tax return. If they think your reasonable conversation is too low, you’ll get audited (and, rumor has it that they’ll be checking much, much more frequently in the future) .
If you’re playing games with a reasonable compensation, a reasonable compensation audit will be a nightmare. The IRS will come in, say your salary is too low, say they are recharacterizing your distributions (which weren’t originally self-employment taxed) as salary, and all the unpaid self-employment tax including penalties and interest is due immediately. If you’re playing games, you’ll, at best, compromise and at worst, get blown out of the water.
Assuming you don’t get caught by a reasonable compensation audit, the second problem is Social Security. By paying an artificially low amount of self-employment tax, you’re also paying an artificially low amount of Social Security tax and paying way less into the system than you should be. We can argue about whether or not Social Security will exist 20+ years from now. But, the reality is that Social Security is still a major part of most Americans’ retirement plans. By artificially reducing your payments into the system, you’re also artificially reducing your Social Security income in retirement.
part ii: why S-corps aren’t always a good idea
focus on the net savings, not the tax savings
All that said, S-corps look like the obvious best choice because they pay less tax than other business structures. And, this is where many well-meaning commenters, poorly researched blog posts, and irresponsible accountants leave it.
But, there’s much more to S-corps than just reasonable compensation, distributions, and employment tax savings. You need to consider the additional costs to running an S-corp and other potential issues.
The big three issues are:
- the cost of running payroll and the annual S-corp tax return
- reduction of the Qualified Business Income deduction
- local tax issues
running payroll and filing taxes costs money
As you already know (because you totally didn’t skip ahead), S-corps must run payroll to pay their owners. If your business isn’t already running payroll, this is a new and additional cost. The cheapest payroll software I’ve seen cost in the neighborhood of $20-30 per month. That means you’ll pay, at least, an extra $250 to $350 per year just to run payroll. (You can also run payroll the old school way where you manually prepare tax returns and remit taxes but it’s a fucking nightmare. Just pay for the software.)
If your business has been running payroll, you’ll still have to account for the Federal Unemployment Insurance (and state unemployment insurance) which you weren’t previously paying through your self-employment taxes. That’s an extra $420/year.
On top of that, S-corps report their revenue and expenses on a separate business tax return. If you were operating as a sole proprietorship or single member LLC, this is a new and additional cost. Depending on your accountant, an S corp tax return could cost you an extra $500- $1,000 per year.
All in, a solo freelancer converting their SMLLC into an S-corp will need to spend, at least, an extra $700 per year in additional administrative costs. You’ll need, at least, a $1,000 employment tax savings to make the change worth it. And, that isn’t even including the next few issues or slight business fluctuations that might affect savings.
QBI deduction is based on profit
Firstly, S-corps can deduct all the same business expenses that a sole proprietorship or single member LLC can. Certain deductions will have to be restructured and deducted slightly differently (namely, health insurance will now need to be run through the owner salary as a reimbursement), but most remain unchanged with one major exception.
The Tax Cuts and Jobs Act (aka tax reform) added a new business deduction called the Qualified Business Income Deduction. It’s an incredibly complicated deduction with different income thresholds, calculations potentially involving your salaries and capital assets, and even works differently depending on what type of business you operate. But, to oversimplify things, many micro-businesses (except C-corps) are eligible for the Qualified Business Income Deduction. These businesses can deduct 20% of their profit as a deduction.
The keyword in there is profit. Your profit is your revenue minus your expenses. S-corps have one additional expense that sole proprietorships don’t – the owner’s salary. An S-corp owner’s salary reduces the S-corp’s profit. For example, if a sole proprietorship has $100,000 left over after all expenses, it has a $100,000 profit. An S corp would also have to run salary for the owner. If reasonable compensation was $50,000, that S Corp would only have a $50,000 profit.
This reduction in profit, and reduction and Qualified Business Income Deduction also reduces the net tax benefit of an S-corp. What might seem like an obvious reduction and self-employment tax an easy choice becomes much murkier when to include the QBI deduction.
Local tax issues
There’s a myth that s corps don’t pay tax. The truth is that S-corps don’t typically pay federal income tax (they do in some cases, but this blog is tax 101 and that topic is tax 350). But, they do pay income, excise, and/or franchise taxes in certain states and cities. In many of these locations, the increase in local tax will typically completely wipe out the benefit of the self-employment tax savings. Once you include the additional costs of running an S corp and the reduction in QBI, an S-corp can wind up costing you money in those jurisdictions.
S-corporations are not a one-size-fit-all entity. They save tax by legally reducing your self-employment tax. But, come with a few downsides and additional costs. Before forming an entity and making the S-election, you should run the numbers to make sure it makes sense for your business and financial situation.
Please don’t open an S-corp because some guy on the internet told you to.