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According the IRS, almost three quarters of corporations were S corporation flow-through entities. Given their popularity, it begs the question: Should I become an S Corp?
In this post, we'll first touch on the benefit of becoming an S corp and then discuss a few points of consideration to ponder to help you decide if the S election is right for you.
Benefit
The primary benefit of electing S corporation status is reduction in taxes. The income that flows through from your business when you're self-employed filing as a Schedule C (or single member LLC) is taxed as self-employment income and subject to the 15.3% self employment tax rate. Using the S election, the income that flows through to you, the owner, is not consider self-employment income and therefore not subject to the self-employment tax.
To help illustrate, take a look below. The example shows a business generating $100,000 in gross revenue.
In the Schedule C column, the entire $100,000 is considered self-employment income and is subject to the self-employment tax. In the W-2 | S corporation column, the owner has classified $60,000 of her income as wages and the remaining net profit as S Corporation K-1 income, which includes some tax deductible costs of administering the entity. As you can see, by electing S status, there's approximately a $2,500 difference in tax savings!
Often, the conversation stops here. Let's take a few minutes to hit on some points that are worth considering before making the election.
Traps for the Unwary
Reasonable Compensation
Sign me up for the S Corp! I'll pay all of the earnings in distributions! Think again. You must pay yourself a reasonable compensation.
The idea is that part of the business earnings are due to you being an employee and part are due to you owning the business as an owner. Therefore, you must allocate a portion, or potentially all, to salary. This is going to vary on a variety of factors including your industry and profession - reasonable compensation for a bookkeeper is going to be different than that of a dentist, your role in the company, experience, compared to other employees in the company, etc. Unfortunately, there's no exact formula or form given to us that explicitly calculate this number.
The IRS uses a facts and circumstances approach to judge reasonable compensation. Therefore, it's a good idea to perform a reasonable compensation study and use those findings to help base your salary portion. Additionally, memorializing them in the minutes of the business as well as periodically updating the numbers can help provide a defensible argument to the IRS. Reasonable compensation is an area that the IRS like to litigate in the tax court and having documentation, while won't guarantee a win, can go a long way to helping make your case.
Shareholder Restrictions
Before we dive into this next section, it's important to keep in mind that in 2014, approximately 64% of S corporation filed tax returns were owned by one shareholder and that approximately 26% were owned by 2 owners; approximately 90% of all S corps had 2 or fewer owners. Therefore, this section may not be entirely applicable to your situation but it's a good idea to at least review the considerations before making a final decision.
There are a number of important restrictions placed on shareholders. Let's go over four.
First, you cannot have more than 100 shareholders and they must be individuals (with some limited exceptions). This isn't going to be a problem for most businesses as that are owner-operated as mentioned above but if you're looking to attract outside investors then this can be a deal breaker. It can also add some complexities to estate planning. Again, while it's not usually an issue it is certainly a good time to bring in a skilled estate planning attorney to ensure there are not deleterious ramifications.
Second, S corp shareholders must be U.S. citizens, legal residents, estates, or certain types of trusts as touched on above with regards to estate planning. While you may not be looking to raise capital from hundreds or thousands of investors, in today's increasingly global environment, you may decide to start a business with a family member or colleague that doesn't fit the criteria. For example, you and your Australian citizen cousin living in Australia wouldn't be able to elect S status for your outsourced IT company; you'd have to look at other tax structures to run your business.
Third, distributions must be pro-rata in the same proportion of ownership. This means that if you have 4 owners that each own 25% and the S Corporation makes a $100,000 distribution, each owner would then need to receive $25,000. You can have different salaries based on the work you do for the business but your distributions must be pro-rata based on ownership. If you're the only owner of the business, like many S corps, then this isn't a problem. However, other tax structures may provide more flexibility than an S corp may provide.
Fourth, you can't have separate classes of stock. This is outside the scope of this article but if you're looking for maximum flexibility then the S corp status may not be the right choice for you.
Additional Compliance
Running a business requires keeping track of income and expenses, something that you should be doing regardless of your tax classification. However, when you elect S Corporation, you'll need to start paying yourself payroll like any other employee. If it's only you, this is going to be an additional cost to run payroll. If you've already hired an employee then this cost might be marginal. Additionally, you'll be responsible for federal and state unemployment taxes and their respective filings that you were likely not subject to as a self-employed, Schedule C individual.
In addition to payroll responsibilities, S Corporations have their own separate tax form. This form, Form 1120-S, is an informational form that reports the income and expenses of the business to the IRS. The owner(s) receive a Form K-1 that reports their share of those income and expenses which are then reported on their own individual return.
Bottom line: those additional compliance costs can eat into or exceed any potential tax savings that may occur from going from self-employed schedule C to electing S status. See the table below.
Using the same $100,000 revenue business from before, you can see that the $2,500 in tax savings is eliminated by additional compliance costs to run payroll and file the tax returns. In fact, when considering compliance costs, it's more costly to run the business as an S corporation rather than a self employed sole proprietor on Schedule C.
Grow Into the S Corp Status
In our below example, we use a $500,000 business. As the business grows in revenue, the same owner pays themself a bit more in salary but continues to retain a bulk of the profits as distributions of the business. In this example, the tax savings provided by the S corp election is approximately $34,500, which more than makes up for any additional compliance costs.
It should be noted that as a business grows in size, it may have already outsourced its accounting, hired a tax accountant, and perhaps hired an internal employee with ensuing payroll processing costs. Therefore, the marginal cost of electing S corp status may not be all that much higher.
Taking into consideration the above factors, it may make sense to hold off and grow into the S Corporation election when the tax benefits outweigh the additional compliance aspects.
Miscellaneous
There's are a few other miscellaneous items to keep in mind.
First, what's your exit strategy with the business? While many S corps are owner operated, probably the vast majority, occasionally a business is built with a known exit. This decision can affect the choice of entity.
Secondly, the way assets can be moved into and out of the S corp can be a bit tricky. If you plan to move assets other than cash into and out of the business, especially amongst ownership, another entity may make more sense as the movement of an asset can trigger taxable income to an unexpecting owner.
The S corp is designed to provide tax benefits to business owners in a more streamlined fashion. The two major trade-offs are that it does have some additional complexity over say a sole proprietorship and it may not have all of the flexibility that your particular situation requires. However, for 4.4 million businesses in 2014, the S corp status was the entity of choice.
If you think an S Corporation might make sense for you, book onto our calendar!
Cite:
SOI Tax Stats - S Corporation Statistics. (2020, April 17). Retrieved August 03, 2020, from https://www.irs.gov/statistics/soi-tax-stats-s-corporation-statistics
Disclaimer
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