Should I make an S Corp election?

If you’re a sole proprietor or a single member LLC, you’ve probably heard some version of this advice lately:“If you're making more than $60,000 in net profit you should elect S corporation status, you'll save thousands in taxes.”

It might be showing up in your inbox, your social feed, and increasingly coming from CPA firms. The message seems simple, confident, and appealing. It’s also terribly incomplete.

To be sure, for many small businesses there are real and significant tax savings to be had with an S Corp election, and the increased compliance costs make sense. But too many times I see small businesses trading tax savings for new administrative costs, adding compliance requirements and complexity, ultimately costing businesses more than they are saving in tax. So, before you make the switch, it’s worth taking a deeper look to understand what the potential tax savings of an S Corp election are actually based on.

What’s Being Sold

At the heart of the S Corp election pitch is the idea of reducing self-employment tax. And while that is a core element of the S Corp election's benefit, it is one piece in a huge puzzle of whether this election is right for your business.

First, let's understand how an S Corp election creates a self-employment tax benefit: As a sole proprietor, your net income (what you take home/claim on your taxes after all expenses) gets reported on your personal taxes as self-employment income, which is subject to a 15.3% self-employment tax. Electing to be taxed as an S Corp would allow you to spilit that same net income into "labor" (a salary that is subject to payroll/self-employment taxes) and "profit" (a distribution which is not subject to self-employment tax). That separation creates an opportunity for tax savings, specifically self-employment tax savings (all your net income in either case is still subject to income tax).

Here's a simplified example that is often how the S Corp election is "sold" to sole proprietors and single member LLCs:

Let’s say your business generates $100,000 in profit. That means as a sole proprietor/single member LLC you'll report that income on your personal taxes and you'll pay $15,300 in self-employment tax. With an S corp, you can split that $100,000 into a $50,000 salary, for which you'll pay $7,650 in payroll tax, and a $50,000 profit distribution, for which you'll pay $0 self-employment tax. Boom, tax savings of $7,650. Sign me up for that S Corp, right?

Not so fast. Let's take a more detailed and more accurate look at this example. (For the moment, we're going to ignore the question of how to determine your salary amount - but we will come back to that as it has major implications).

First, in order to qualify for an S Corp election, your business must:

• establish an LLC if you don't already have one ($300-$700 one time, $200 annually)

• set up and run regular payroll ($750-$1800 per year)

• file a separate 1120S business tax return ($800-$2000 per year)

You'll also need to make sure your financial record keeping is top notch, which will likely require contracting with a high quality bookkeeper ($1800-$3000 per year).

If we go back to our $7,650 self-employment tax savings for the S Corp and factor in the new expenses we'll have for administrative compliance, you'll see that on the low end of the administrative costs ($3350) the tax savings is now $4,300, and on the high end ($7500) the tax savings drops to $150.

But wait, there's more! Remember the question of how to determine what your salary will be? The IRS has a lot to say about this, namely that you must pay yourself a "reasonable" salary, which means it is in line with the market value of someone in your profession with your experience. And you better be able to justify that salary with a real methodology (market analysis, data, etc.)

Let's say our sole proprietor in our example above is a graphic designer, the average annual salary of graphic designers (according to the Bureaur of Labor Statistics) is around $64,000. Using that as our salary portion, the the self-employment tax savings after average admin costs now is around $1900. If you're profession commands average salaries of $75,000 you're self-employment tax savings would be completely wiped out by the administrative costs. And these are average salaries, most business owners are owners because they are better than average. So the average salary might not meet the IRS's "reasonable" standard given the owner's experience level.

Unreasonable (too low) salaries are the biggest reason for S Corp audits, so you can't afford to lowball this in the name of maximizing tax savings. And when audits happen the IRS can and does reclassify income and assess back taxes and penalties. So the strategy only works if the numbers hold up under scrutiny.

And we haven't even talked about factoring in the Qualified Business Income (QBI) deduction. As an S Corp the amount you pay yourself in salary does not qualify for the 20% QBI deduction. I'm not a math genius but I do know that 20% is greater than 15.3%, so if you're considering an S Corp election, do yourself a favor and get a qualified professional to run a comprehensive analysis to make sure this is the best move for your business.

The S corp election isn’t a shortcut. It’s a structural change that works well for certain businesses at a certain stage. But, right now, it’s being marketed as a near-default move.

If your business is already stable, profitable ($80-100K a year and growing), consistently growing, and operationally disciplined, it may be worth considering. If your business is not those things, you’re often better off focusing on fundamentals—profitability, systems, and clean financials—before adding the extra administrative work and complexity in the name of tax savings.

Either way, if this is a question you have been asking yourself about your business, I can help. Contact me for a free 30 minute consultation on this or any other tax strategy questions you have.

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