So when will an S-corp actually save you money on taxes?
One of the biggest surprises to most new small business owners is the unfortunate fact that all self-employment income is subject to the 15.3% self-employment tax (up until the Social Security wage limit, at which point self-employment tax drops to 2.9%). And this tax is in addition to ordinary federal and state income taxes paid on your net income. Brutal, right?
Fortunately, electing to have your business entity be taxed as an S-corp can sometimes yield significant savings. Granted, going the S-corp route does come with additional compliance requirements (and related costs), but depending on your circumstances, the tax savings can more than justify the additional time and expense.
What exactly is an S-corporation?
Contrary to what a lot of people think, an S-corporation isn’t actually a legal entity in and of itself - it’s a tax status election for an LLC or a corporation. So what exactly does that mean?
Let’s start with the example of a single-member LLC (an LLC owned by one member) - the most applicable example for most small business owners. When you create an LLC, you actually have several options as to how you can be taxed. As a single-member LLC, your entity will by default be taxed as a disregarded entity, meaning your business income will flow through to Schedule C on your personal return, and your LLC will not need to file a business return. However, you also have the option to elect to be taxed as either a C- or an S-corporation. Similarly, a multi-member LLC (owned by multiple members) will by default be taxed as a partnership, but can also elect to be taxed as either a C- or an S-corporation. Within this article, we’ll limit our discussion to entities owned by a single member - S-corp considerations get a bit more complicated when there are multiple owners.
When you elect for your entity to be taxed as an S-corp, all income, losses, deductions and credits still flow through to your personal return. However, net income related to your S-corp now no longer flows through to Schedule C - and is therefore not subject to that pesky self-employment tax. Notice I said net income… because S-corps are still required to pay their shareholders “reasonable compensation”, on which the IRS will still collect payroll taxes. But any business income beyond that “reasonable compensation” figure (and associated payroll tax) will be shielded from the 15.3% self-employment tax.
How much can an S-corp really help you save?
Let’s take a simplified example to illustrate the potential tax savings the S-corp election can provide. For now, let’s assume that you’re self-employed, you own a business (through a single-member LLC) generating $100,000 in net profit, and you’ve elected to be taxed as a disregarded entity. Under this fact pattern, come tax time, you’ll owe $15,300 (15.3% x $100,000) in self-employment taxes.
Now let’s assume you elect to have your LLC taxed as an S-corp, and you’re able to establish a reasonable compensation figure of $60,000. Your $60,000 salary will still be subject to a 15.3% payroll tax (a total of $9,180), but the remaining $30,820 of net profit ($100,000 business profit - $60,000 in salary - $9,180 in payroll taxes) will be shielded from that 15.3% self-employment tax, yielding a potential self-employment tax savings of several thousand dollars!
Now, in reality, the calculation is not actually this simple. Half of your self-employment tax is deductible, and you will receive a larger qualified business income (QBI) deduction going the Schedule C route vs the S-corp route. But, in many cases - including in the example above - the savings on self-employment tax more than outweigh the impact of a reduced QBI deduction. Before deciding whether or not an S-corp is the right tax choice for your business, consult with a CPA (like us - reach out here!) to have them run the numbers under both tax scenarios to see which structure leaves you with a lower tax bill.
“Reasonable compensation” - the cornerstone of any S-corp
As you can see from the example above, the spread between your reasonable compensation (your salary) and your business's total net income is the biggest driver of potential tax savings generated by the S-corp election. But what exactly is reasonable compensation, you might ask?
Unfortunately, the IRS hasn't released any explicit guidance for determining reasonable compensation, and have in fact stated that they don’t have any specific guidelines for doing so - reasonable compensation depends on the facts and circumstances of each individual situation, and should pass the “sniff test”. For instance, the owner of a barbershop might be able to justify reasonable compensation of $45,000 - 50,000, but for a physician, that salary is obviously ludicrously low. With that in mind, there’s a couple methods that I personally like to use when determining reasonable compensation for my clients.
The first method is referencing the Bureau of Labor Statistics’ data on a particular job position or industry - in my eyes, this is a defensible approach because you are literally using government data to determine reasonable compensation. Another good methodology is the “replacement cost” approach - that is, what would it realistically cost to hire someone for your position? Again, reasonable compensation is going to depend on the facts and circumstances of every situation, but those two methodologies will at least provide a good starting point.
Obviously, the taxpayer wants to set reasonable compensation as low as possible to avoid as much self-employment tax as possible. However, it is important that any compensation figure be defensible and data-driven - the more data you have to back your reasonable compensation number, the weaker the IRS argument for forcing you to raise the figure in the event of an audit. Note that oft-cited guidelines such as “60 % salary, 40% distributions” are not data-driven reasonable compensation approaches and may not necessarily stand up in the eyes of the IRS.
What additional tax and compliance requirements are associated with an S-corp?
Electing to be taxed as an S-corp does come with additional hurdles. First, you have to actively elect S-corp status by filing Form 2553 with the IRS. Though this is technically supposed to be filed within two months and fifteen days from the beginning of the tax year the election relates to (or from the date you created your LLC/corporation, if you created the entity mid-year), the IRS does provide for late election relief. One common mistake folks make is to just file (or have their CPA file) an S-corp tax return without first electing for S-corp status - this will lead to the return getting rejected, since the IRS has no existing record of that entity having been classified as an S-corp.
Next, you need to ensure you’re actually paying yourself the reasonable compensation that you set for yourself. There are quite a few payroll platforms you can use to run your own payroll - personally, I think the best bang for your buck is Gusto (and it’s easy to use as well). While you can run payroll yourself without using a payroll platform, the $50/month or so that you’ll pay for Gusto is well worth it when you consider that they handle all your state and federal payroll tax remitting and reporting requirements.
Finally, you’ll need to ensure that you’re filing all applicable state and federal S-corp tax returns. Unlike an LLC classified as a disregarded entity, where all business income gets reported on Schedule C of your personal return, an entity classified as an S-corp will need its own separate return(s). As such, you should expect a corresponding increase in tax prep costs - and this increase in accounting costs (along with your payroll processing costs) should actually be factored into your decision as to whether an S-corp makes sense for you and your tax situation.
Generally speaking, when does an S-corp election make sense? And when is it a bad decision?
Before making an S-corp election, definitely have your CPA run the numbers for you as to whether you’ll actually end up with a lower tax liability - and whether your savings will outweigh your additional accounting and compliance costs. With that said, here’s some general guidelines as to when an S-corp election will often make sense:
Net profit significantly exceeds reasonable compensation: the biggest opportunity for an S-corp to generate tax savings is when the business’ net profit is much greater than your reasonable compensation - that’s because the S-corp election will allow you to shield your net profit (after salary and payroll taxes) from self-employment tax.
Your industry requires you to operate through a corporation: in certain states, professionals in some industries are required to operate through “professional corporations” (for instance, freelance doctors in certain states). If you’re required to operate through a professional corporation, you’re much better off electing to be taxed as an S-corp (vs the default tax treatment as a C-corp, which will subject you to double taxation)
On the flip side, here’s a couple scenarios where an S-corp election can sometimes actually lead to an increased tax liability:
Net profit is not significantly higher than reasonable compensation: when net profit is not significantly higher than reasonable compensation, not only are the self-employment tax savings generally canceled out by increased payroll and accounting costs, you also end up reducing your QBI deduction, generally leading to a higher tax bill.
Reasonable compensation is above the Social Security wage limit: once reasonable compensation exceeds the Social Security wage limit ($168,600 in 2024), the self-employment tax savings associated with an S-corp can sometimes drop off dramatically - beyond that wage amount, the only payroll/self-employment tax that you’re required to pay is the 2.9% Medicare tax. As such, the tax savings on Medicare tax are often outweighed by the loss of your QBI deduction. That being said, the viability of an S-corp this scenario is not always black and white - there are still certain tax savings strategies (such as the pass-through entity tax, or PTET, election available in certain states) that can make an S-corp make sense at this income level.
Once again, always discuss a potential S-corp election with a CPA and have them run the numbers for your particular situation. There are so many factors that affect whether an S-corp election is the right decision for you (marriage status, industry, business profit, etc) that there is no one-size-fits-all answer.
At Doug Johnson CPA, we’re experienced when it comes to working with small business owners and advising them on the most tax-advantaged structure for their businesses. For a free consultation to discuss your tax situation and whether you could save on taxes by making an S-corp election, reach out anytime and we’ll get some time on the calendar to chat!