Why You Should Probably Be An S-Corp

I still remember the first time I spoke with a CPA about doing my taxes and they asked if I was an S-Corp. I said I wasn’t and they said I should be. I asked why and they said it’s better. “How?” I asked. “It’s better for you” was all I could get. What good does it do to simply tell someone something is better if you can’t provide any explanation about why it’s better?

So let’s just clarify why an S-Corp can be better for you.

First, we need to acknowledge that being an S-Corp doesn’t require you to be registered in your state as a corporation. You can be an LLC with the state and still register with the IRS as an S-Corp.

The quick answer to why an S-Corp is better is that it allows you the owner to be on your own payroll making more of the taxes that you have to pay anyway a deduction for the business which brings down your total taxes for the year. It saves you money on taxes.

So how exactly is does an S-Corp save you money on taxes? I’ll keep the examples overly simple to illustrate things clearly, but let’s say you own Company, LLC and had a net profit of $100,000 at the end of the year. That $100,000 is passed through to the your personal taxes. So you pay taxes on the $100,000. If your total effective tax rate is 25%, that’s $25,000 in taxes.

But let’s assume Company, LLC is taxed as an S-Corp and you are on the payroll.

So let’s assume your total pay for the year is $100,000, $50,000 is your reasonable salary (see section on reasonable salary below) through payroll and 50% through owner’s draws (that half is taxable whether or not you actually pay it out to yourself). That sounds like it’s the same right? $100,000 in profit minus $50,000 on payroll (which is taxed) is still $50,000 taxable income, so the taxes are still the same, right? Wrong.

When the owner is on payroll, the employer tax is paid by the business making it an expense (a tax deduction), reducing the taxable income. If you aren’t on payroll, you pay self-employment tax of 15.3% with your tax return at the end of the year. But if you’re on payroll, half of that comes out of your paycheck and half is paid by the business the business.

So the business pays the employer payroll taxes for your payroll. Half of 15.3% is 7.65%. 7.65% of $50,000 is $3,825. Okay, so that $3,825 is paid by the business instead of by you on your personal tax return, it’s still the same right? No. Because it’s an expense, you no longer have $100,000 in taxable income, after that $3,825 deduction (from the business paying its half) you now only have $96,175 in taxable income (combining your payroll and the remaining profit of the business). Assuming a total effective tax rate of 25%, that saves you $956.25 in taxes when all is said and done. So although it’s not saving you a fortune, $956.25 for simply checking a different box (or submitting a single form if you’re already registered with the IRS as an LLC) is a lot of money. I bet under any other circumstances, getting $956.25 for checking box A instead of box B or submitting a single piece of paperwork would seem too good to be true and you’d jump at the chance. And that’s only in one year. Do that over and over every year and it’s even more free money. If your reasonable salary is higher than $50,000 per year (which will be the case for most business owners), the savings get even higher even faster.

So now we see why it’s so beneficial to be an S-Corp.

But What Are the Downsides of Being an S-Corp?

The biggest downside is probably that you have to pay the reasonable salary. The IRS defines a reasonable salary as replacement cost (their definition is longer and a little more vague, but the meaning is the same). So if you would hire someone at $50,000 per year to do what you do for the business (at least the main day-to-day tasks, not necessarily every single thing an owner ever does, just the main functions they provide to the business), then you shouldn’t pay yourself more than about $50,000 per year. A reasonable salary is completely independent of profit and loss. “Rules of thumb” recommending the salary is 50%, 60%, etc. of total income for the year are wrong.

Most owners will have a higher reasonable salary, but this is something that you will want to review with your tax preparer/CPA (either before you become an S-Corp or at least before the end of the first year if you’re already an S-Corp).

There are rules about the pay such as it being a reasonable salary. You have to pay the full salary before you can pay yourself any owner’s draws/distributions. If you can’t pay the full salary you can defer some or even all of it to a later year. I don’t think the IRS will let that go on forever though, so talk with your CPA before becoming an S-Corp if you’re not already profitable enough to cover that full reasonable salary.

So the only real downside is that unless you already elected to be an S-Corp, you’ll probably want your CPA to send in a form to the IRS for you that changes your election to S-Corp. They will send a form back in the mail, scan that, email it to yourself, save it in a cloud-backed way (such as Microsoft OneDrive), and save it forever because apparently it’s impossible to get a second copy of it.

If you have any other questions, feel free to email me.