Why should you form an S Corp? Over 70% of U.S. businesses are operated as sole proprietorships—and it’s no surprise. Sole proprietorships are the easiest business structure to form and operate. Plus, you control all the decisions you make about your business (no shareholders to worry about) and don’t have to worry about filing separate tax returns for your business since it all goes on your personal tax return.
That’s all great, but if you’re a sole proprietor, your tax obligation can be a significant burden.
To start with, sole proprietors are responsible for paying 100% of their self-employment taxes to cover Social Security and Medicare. If you were working for someone else, you’d only be responsible for half of those expenses, as your employer pays the rest. Essentially, you’re paying both personal and business tax on every dollar you earn.
Another tax disadvantage for sole proprietors is that they are taxed on all profits of the business, less any deductible expenses.
Compare this scenario with another increasingly popular business structure—the S Corporation.
What is an S Corporation?
Designed with small businesses in mind, in an S Corp arrangement, the business owner is treated as an employee and draws a salary from the business’ profits. This is good news because only these wages are subject to self-employment tax; the remaining profits are distributed to the owner or among the owners as dividends on which you pay regular personal income tax (personal tax rates are lower than those levied on businesses). It’s a strategic move that could save you a large amount of money on self-employment taxes.
How Much Can You Save?
For those of you who prefer numbers, consider the math:
Say you earn $100,000 a year as an S Corp. Out of that you pay yourself a salary of $40,000. The remaining $60,000 of leftover profit is your dividend. That $40,000 of wages is subject to self-employment tax, roughly 15%. (approx. $6,000). The profit however, is not subject to this tax, so you’re saving $9,000 right there. The income tax you pay to Uncle Sam and your state government on the dividend varies from business to business, but the self-employment tax savings add up quickly.
Paying Yourself as an S Corp
A critical part of being an S Corp is determining exactly what you will pay yourself because this will determine your tax position.
Unfortunately, this is where it gets a little fuzzy. The IRS expects to see a salary that is commensurate with industry averages and is reasonable for the type and amount of work done. Pay yourself too little in salary, and there is a chance that the IRS will scrutinize the division of salary versus distributions. This may result in an audit, which could open you up to back taxes and penalties.
Now here’s the rub. The IRS doesn’t provide precise guidelines on what percentage S Corp owners should draw as a salary or pay its employees. Instead it outlines what it considers “reasonable compensation“. The IRS lists some factors that determine a reasonable salary, which you can read about here. A good rule of thumb, according to Mark Stansbury of The Stansbury Law Firm, is to pay yourself at least half of what you take out of the business through payroll.
Costs of an S Corp
Now, all those savings come at a price, so it’s important to talk to your accountant/tax attorney about the true costs of an S Corp in your state. Some states apply additional fees and taxes to S Corps. There are also formation, legal, and accounting costs (and quite a lot of paperwork) to consider.
How to Form an S Corp
Technically an S Corp isn’t a structure in itself, it’s either a corporation or limited liability company that has elected through the IRS (called the S election) to receive S Corp tax savings. You can make this election via the IRS website. You must file the election no more than two months and 15 days after the beginning of the year or anytime in the preceding tax year to ensure the S Corp election takes effect for this tax year.
There are eligibility requirements too. You must be a domestic business with legal residency or citizenship status, as well as other caveats.
Take Counsel First
Becoming an S Corp requires careful consideration and weighing up the pros and cons specific to your business. Talk to the pros (accountant and/or tax attorney) to advise whether a corporation or LLC is right for you, what the risks and rewards will be, and what administrative responsibilities are involved. They can also help you keep your books and tax obligations in order once you’ve made the shift from sole proprietorship.