One of the most frequent questions I get from new entrepreneurs is whether their business should be an s-corp. I give them the typical lawyer answer: it depends.
What is an s-corp?
A slight variation of “should I be an s-corp?” is “should I be an s-corp or an LLC?” Most small businesses I work with are both—i.e., an LLC taxed as an s-corp. “S-corp” is a tax designation, not a legal designation.
The default tax treatment for a limited liability company (“LLC”) that has only one owner (a “member” in LLC parlance) is “disregarded entity.” For tax purposes, a disregarded entity does not exist separately from its owner. If that owner is a person, rather than another business entity, they will report the income and expenses from their LLC on Schedule C, E, or F on their personal tax return, depending on the nature of the business. The LLC still exists separately from the owner for legal purposes.
The default tax treatment for an LLC with multiple owners is partnership. A partnership files a partnership tax return each year on Form 1065. However, the partnership does not pay its own taxes. Instead, the income flows through to the owners’ personal tax returns via Schedule K-1. Partnerships are thus known as “flow-through” or “pass-through” entities. A partner includes the amount shown on the K-1 on their personal return.
An LLC can also choose to be taxed as a regular corporation (i.e., a “c-corporation”) or an s-corporation (i.e., an “s-corp”). A regular corporation exists completely separate from its owner(s), files its own tax return, and pays its own taxes. Owners receive their share of after-tax corporate profits via dividends, which represent personal income. Meanwhile, an s-corporation is a “flow-through” or “pass-through” entity in the same manner as a partnership. An s-corporation files an s-corp tax return each year on Form 1120-S; it does not pay taxes on its income, but instead passes that income to the owners via Schedule K-1.
What else should I know about disregarded entities and partnerships?
A disregarded entity is the most straightforward tax treatment available. For tax purposes, it is the same as a sole proprietorship. All you do is add an extra schedule to your personal return. It is easy to see that you incur income tax on your business profits because that figure is included on your personal return. Besides income tax, you also incur self-employment tax of 15.3% on your net profits (assuming your business is not a passive activity like real estate).
If you are a partner in a partnership, your share of the partnership income each year is also generally subject to both income tax and self-employment tax.
Self-employment tax is the employee and employer shares of Social Security and Medicare taxes. It is fair that you pay both sides because you fill both roles. Social Security tax is 6.2% up to the annual wage base, and Medicare tax is 1.45% with no limit. You typically see these taxes deducted from your gross pay on your pay stubs, and they show up in boxes 4 and 6 on your W-2. However, most people fail to realize that their employer has to match the employee withholdings. (Who can blame them? There is no reason to think about your employer’s tax responsibilities unless you are an employer yourself, or perhaps a union negotiator.) If you earn $1,000, and pay $62 in Social Security and $14.50 in Medicare taxes, your employer also has to chip in $62 for Social Security and $14.50 for Medicare in addition to your contributions.
The Social Security wage base for 2024 is $168,600. This represents the maximum earnings on which you will pay Social Security tax, whether from wage income, self-employment income, or both.
An additional Medicare tax of 0.9%, with no employer match, applies to earnings above certain thresholds in a calendar year.
Because federal taxes are a pay-as-you-go system, you need to pay the extra tax burden as a result of your business profits throughout the year. Business owners typically do this via quarterly estimated tax payments, but another option is to increase your income tax withholdings from a W-2 job by a large enough amount to cover these additional amounts.
What else should I know about s-corps?
The beauty of s-corp treatment is that unlike disregarded entities and partnerships, you are not subject to self-employment tax on your net business profits. Amazing, right?! Just choose to be an s-corp, and say bye-bye to self-employment taxes!
Not so fast. There is a catch. (Of course there is a catch.) As an s-corp owner, you must pay yourself a reasonable salary for services rendered to the company before you can distribute the remaining profits. If you choose the s-corp route, you must actually wear your employee hat, not just your owner hat.
Failure to pay yourself a reasonable salary could result in the IRS reclassifying all your profit distributions as salary.
In theory this makes sense: If I owned your business, but you were doing all the work, I would pay you a salary for that work and keep the remaining profits for myself. When you wear both the employee and employer hats simultaneously, take one off at a time: Pay yourself a salary first, just like you would pay any employee, before profit distributions.
Payroll entails a lot of complexity. After registering for payroll accounts with the relevant federal and state tax authorities, you have to figure out how much to pay yourself—remember the “reasonable” salary requirement—and then actually pay yourself, figure out tax withholdings, figure out your employer tax burden, remit those taxes to the government, file quarterly and annual payroll tax reports with the IRS and state agencies, and then issue W-2s at the end of the year. Because of all the extra hassle involved, most folks outsource this to a professional.
Your payroll taxes replace the self-employment taxes. Indeed, your federal payroll taxes include federal income tax withholdings taken from employee paychecks, Social Security and Medicare taxes taken from employee paychecks, and the Social Security and Medicare employer match. (You also have federal unemployment tax, plus state and local payroll taxes, but those are relatively small.)
What difference does it really make?
Your payroll taxes as an s-corp replace your self-employment taxes as a disregarded entity or partnership. In other words, you pay payroll taxes on some of your income rather than self-employment taxes on all of it. (You still have to pay income tax either way.) State and local payroll taxes will also apply, even if you live in a no-income-tax state. Unemployment, paid family leave, and transit taxes are common examples.
Additionally, you will incur expenses for a payroll service and then for a separate business tax return. (Your payroll provider can be your tax preparer, but you can also use separate professionals.)
For example, assume you make $100,000 profit from your single-member LLC that follows the default tax treatment as a disregarded entity. Your federal income tax on that amount is $22,000. You also owe self-employment tax of $15,300 (i.e., 15.3%) on the net profits. You pay the $37,300 total—the income tax and self-employment tax combined—in quarterly installments of $9,325 throughout the year. When it comes time to file your taxes, you simply report the $100,000 profit on Schedule C, a $22,000 income tax liability, $15,300 in self-employment tax, $37,300 in estimated tax payments, and no refund or balance due.
You would actually owe somewhat less in self-employment tax, because one-half of it is deductible when computing net profits, but we will ignore that nuance for the ease of illustration.
Now instead assume that you had elected s-corp status. (More on that below!) You still have the same $22,000 income tax liability. Out of that $100,000 profit, you paid yourself a reasonable salary of $60,000. You owe payroll taxes of $9,180 (i.e., 15.3% of the $60,000 salary). Your payroll provider schedules the $31,180 total—the income tax and payroll tax combined—to be paid in monthly installments of $2,598.33 as automatic deductions from your business checking account on the 15th of each month, files quarterly reports to reconcile the monthly payments, and issues you a W-2 showing the $60,000 salary and $22,000 in income tax withholdings (plus the employee share of Social Security and Medicare). On your Form 1120-S s-corp tax return, you list $100,000 income, $60,000 salary expense, and $40,000 profit. On your personal income tax return, you show the $100,000 total as $60,000 in salary and $40,000 in business profit, a $22,000 income tax liability, $22,000 in income tax withholding, and no refund or balance due. There are no self-employment taxes on your personal return because you paid payroll taxes through your business.
Your business profit would actually be less because the employer share of payroll taxes—including state and local payroll taxes—would be deductible, but we will again ignore that nuance for ease of illustration.
See the difference? You had the same income tax liability either way, but you paid payroll taxes of $9,180 as an s-corp versus $15,300 in self-employment taxes as a disregarded entity: a tax savings of just over $6,000! Of course, s-corp finances are a lot more complicated, so you outsourced that complication to a payroll provider and a tax preparer—we handle both!—and enjoyed a less taxing life due to your lightened mental load. Your day-to-day operations were also easier because you had small monthly payments rather than larger, less frequent payments—a win in itself, even if all the rest of it came out even. The professional assistance might cost you $1,500 or so. But $1,500 to make life easier and save $6,000 in taxes? Sign me up!
How do I elect s-corp status?
Electing s-corp status is very simple. File Form 2553 with the IRS no later than two months and fifteen days after the start of the tax year for which the s-corp election is to be first effective. If your business operates on the calendar year, this means you need to file Form 2553 by March 15, 2025, for your s-corp election to be effective for 2025. (You can file it any time between now and then.) If you want your s-corp election to be effective for 2024, you are already late. Fortunately, the IRS will excuse the deadline if you have a good reason, and I have been very successful at filing late elections.
For new businesses, your first tax year starts when your business registration is initially effective.
Is it worth it for me?
I come back to my earlier answer: It depends. If you are still in the early stages where you are losing money or making just a small profit, the juice is not worth the squeeze. Your business needs to make a certain amount before adding the additional complexity of an s-corp tips the scales in your favor. I would never advise a business owner to spend $1,500 a year to realize tax savings of only $800. Even if it came out even, I would advise against it, because if you are going to end up in the same place financially, you might as well take the path of least resistance.
The specifics will vary depending on your anticipated profits, reasonable salary, and other factors, but a very basic rule of thumb I have developed over the years is that it becomes worth it to go the s-corp route once you anticipate making around $20,000 or more of profit in a given year. Remember, though, that a general rule of thumb is not a hard-and-fast rule. Everyone is different, so get personalized help to make sure the move is right for you if you are considering making the switch.
Comments