The 411 on S-Corps
S-Corps are one of the most flagrantly promoted tax issues and one of the most misunderstood.
When tax advice starts trending on TikTok, you should be suspicious. One of the most popular trending TikTok Tax Topics these days is S-Corps. “Everybody should be an S-Corp,” say the dancing influencers. “You can save thousands of dollars in taxes! You won’t pay ANY taxes!” Add to that the advice that you can “literally write off EVERYTHING,” and you have a recipe for disaster.
The LEAST you need to know. (Keep reading for the details.)
An S-Corporation is a tax election that requires you to operate your business in a specific way, including keeping accurate books with financial statements, tracking your shareholder basis, and paying yourself a salary that includes tax withholding paid into the IRS on a regular basis, usually monthly. An S-Corporation ONLY offers tax savings if your business has net profits above all your business expenses AND the amount that you pay yourself in salary. If your business is not profitable or is only making a small profit, then you will not benefit from S-Corp status.
The Details
Sole Prop vs S-Corp:
When you first start a business, you operate as a Sole Proprietor. You don’t have to do anything legal to be a business. Just hang out your proverbial shingle and start working. If you choose to form a business entity in your state, you have the option of forming an LLC, a partnership, or a C-Corporation. There is no option to form an S-Corp. An S-Corp is a tax position.
Most individuals and small businesses form LLCs (Limited Liability Corporation). This is an asset protection entity. There is no tax advantage to forming an LLC. The IRS doesn’t even recognize LLCs. If you are a Single-Member LLC, the IRS still views you as a Sole Proprietor – you file your business income on Schedule C on your personal 1040 tax return. If you are a Multi-Member LLC, the IRS views you as a Partnership and requires you to file a separate Partnership tax return, the 1065. (If you are married in a community property state like Texas, you can file as a joint venture on your 1040 return.)
So what is an S-Corp? An S-Corp is a TAX position. As an LLC (or C-Corp), you can request that the IRS tax you as an S-Corp. It doesn’t change your entity – you are still an LLC – it does change how you are taxed.
Yes, there is a potential for some serious tax savings as an S-Corp, but only if you meet certain conditions, which I will get into.
OBLIGATIONS AND REQUIREMENTS
When you ask the IRS to tax you as an S-Corp (an election made by filing form 2553), you agree to operate your business as an S-Corp. This is where most small businesses fail. As a Sole Proprietor, you and your business are seen as one by the IRS. As an S-Corp, the business is separate from you. (Again, this doesn’t affect your state status. The LLC continues to act as an asset protection instrument IF you use it correctly, which, again, most people don’t.)
When you elect to be taxed as an S-Corp, you agree to follow certain rules and regulations that apply to S-Corps. These include:
Filing a separate corporate tax return (Form 1120S) every year, in addition to your personal tax return (increased tax preparation costs – you WILL want to work with a pro).
Paying yourself a reasonable salary, which means paying payroll taxes (Social Security, Medicare, federal and state income tax) and filing payroll reports (Form 941, Form 940, Form W-2, Form W-3, etc.). You will want to use a payroll company.
Keeping accurate and complete books and records for your business, including income, expenses, assets, liabilities, and equity. You should definitely have a bookkeeper.
Maintaining a separate bank account and credit card for your business, and not commingling personal and business funds.
Following the corporate formalities, such as holding annual meetings, keeping minutes, issuing stock certificates, tracking your shareholder basis, and filing annual reports with your state.
These obligations and requirements can be time-consuming, complex, and costly.
Tax Savings
Sole Proprietors report their business revenue and expenses on Schedule C of their 1040 personal tax return. This is basically a Profit & Loss report. Whatever the bottom number says is what your tax is based on. If you made a profit, the IRS assumes that is what you were paid. It doesn’t matter if you did pay yourself that amount or it’s all sitting in the business account or in a savings account. You pay yourself from your business profits through a draw. Just transfer money to your personal bank account at will.
Example
Let’s say your profit for 2023 was $10,000. After you paid your business expenses, $10,000 was left over. First, self-employment tax is applied to this amount. Self-employment tax is 15.3%. This tax is actually your contribution to Medicare and Social Security. If you were a W2 wage employee, your employer would withhold 7.65% from your gross pay to cover this. Your employer pays an additional 7.65% of your gross pay towards your Medicare and Social Security tax. When you are self-employed, you are both employer and employee, so you pay both halves. Second, that profit number ($10k in this example) flows to page 1, is added to any other income, and is the basis for your ordinary income tax. This percentage varies according to your tax bracket. You can also deduct half of your SE tax on page 1, so it’s subtracted from your gross income. If your bottom-line number on your schedule C is a negative number, a loss, then there is no self-employment tax (15.3% x 0 = 0). That number flows to page 1 of your 1040 and is subtracted from your other income.
S-Corp Tax
When the IRS views you as an S-Corp for tax purposes, they require you to operate as an S-Corp, which is different from what you’ve done as a Sole Prop. The business is now completely separated from you on a tax basis.
Even though the business files a separate tax return, the 1120S, the business itself doesn’t pay tax. Instead the profit flows to you in the form of a K-1, and you report the income on your personal tax return. It shows up on page 1. Ordinary income tax is applied to the amount that flows through, but there is no self-employment tax applied to this amount.
The biggest requirement (and the one most people skip over) is that you pay yourself a “reasonable salary.” Reasonable has not been defined but they know it when they see it. Instead of paying yourself through a draw and transferring money whenever you wish, you must pay yourself a salary. You are no longer “one” with your business. You are now an employee of your business and pay yourself a W2 wage. You will withhold federal income tax from your gross pay and pay it in to the government. (Use a payroll company. It’s affordable and makes your life easier.) You will also withhold 7.65% from your gross pay and pay it in to the government towards your FICA (Medicare/SS). As the employer, you will also pay an additional 7.65% towards your FICA. Most of you are paying the EXACT SAME tax that you were as a Sole Proprietor.
There IS a potential to save money on taxes IF your business is profitable ABOVE the amount of your reasonable salary. Additionally, as a wage earner, your income subject to FICA is capped at $168,600 (2024), but there is no cap for a Sole Prop.
Reasonable Salary
Your reasonable salary number is the key. It needs to be high enough to be considered reasonable, but low enough to actually benefit you.
Setting a reasonable salary should not be taken lightly. THIS IS AN AUDIT ISSUE. There are several things to consider when choosing a salary, which can change each year. Your total salary can include your benefits or perks, such as health insurance paid by your S-Corp. The IRS looks at the following:
Your industry standards (a corporate attorney will bring in a higher salary, presumably, than a pet sitter)
Your training and experience
Your duties and responsibilities, as well as the time and efforts you devote to the business (maybe you have a manager who handles most of the day-to-day work)
Payments made to non-shareholder employees (what is your overall payroll?)
The use of a formula to determine compensation (see below)
Your Industry
According to ZipRecruiter, as of December 2023, the average annual salary in Texas is $53,000. If your salary is much less than that, it could be a red flag.
The average salary for a medical doctor in Texas is over $200,000. According to Indeed, the average salary for a housekeeper in Texas is $45,000. The average for a pet groomer is $53,000. It’s $58,000 for a social media manager, $44,000 for a bookkeeper, and $63,000 for an office manager. That doesn’t mean that’s what you pay yourself, but it is one of the things you consider.
If you are a Solopreneur and do everything from booking appointments to providing the service to taking out the trash, your pay should be higher. If you are one of a staff of ten, then your company’s payroll will be spread out to over ten people, allowing you to pay yourself less. A Sole Prop working a low overhead, professional service business with a high profit margin will be expected to have a higher salary. If your business is barely clearing a profit, then there isn’t much money available to pay you a salary. If your business is rolling in revenue, you need to pay yourself a fair share in the form of a higher salary.
The Formula
A popular way to set a reasonable salary, which has not been endorsed by the IRS, is to use a 50/50 or 60/40 rule. Basically, split the business’ profit between salary and distribution at a ratio of 50/50 or 60/40. Again, this is not a set rule and will depend on the other facts and circumstances of your business. What it avoids is paying yourself less salary than distribution, which is a red flag.
Bottom line: the more money your business is making, the more money you should be paying yourself in salary; you are paying 15.3% towards your Medicare/Social Security on that amount (up to the income cap), plus your ordinary tax.
So, where’s the tax savings?
Your reasonable salary is not the maximum amount you can make from your business. IF your business is profitable ABOVE your reasonable salary, then you can receive that money in the form of a distribution. You can pay yourself distributions above your salary throughout the year or as a year end bonus. This distribution is reported on a K-1 and shows up on page 1 of your 1040, but it does NOT have Medicare/Social Security applied to it. That’s a savings of 15.3%!
Example
For example, let’s say you are an attorney in a small practice. You pay a paralegal and an admin assistant. Your firm grossed $450,000 in 2023. Your business expenses were $200,000. In addition, you paid yourself a salary of $75,000 and your staff $100,000. Your net profit is $75,000, which you paid to yourself as a profit distribution. If you were taxed as a sole proprietor, your self-employment tax would have been applied to $150,000 (your salary + distribution). Your tax savings as an S-Corp is $75,000 (distribution) x 15.3%, $11,475. Nice!
But, let’s say your firm grossed $375,000. All the other expenses are the same. You still paid yourself $75,000 but there was no profit to pay a distribution. You haven’t saved any money on taxes, but you still have to abide by the increased regulations of running an S-Corp.
What if you paid yourself a smaller salary? In many situations, you can. But if the salary doesn’t appear reasonable – would an attorney in a six-figure firm really be paid less than $75,000? – then it’s a potential red flag.
RED FLAGS
The BIG red flag is when you have a business that’s grossing six figures, you’re the only employee and you’re not paying yourself a salary at all, or you’re paying yourself a minimal salary. The IRS has said that this is an audit issue for 2024. They are looking at this. Your salary is listed separately on your tax return. It’s easy for the IRS computers to sift through and find those tax returns with a $0 or small number on that line of the 1120S. If you are audited and the IRS decides that your salary is too low, they will reclassify your distributions as salary and send you a bill for the increased SE tax.
My Guideline
I do not recommend even considering S-Corp status until your business is consistently netting near six figures. Notice I said net, not gross. If your business is grossing $200,000 and you’re spending $200,000 with nothing left over to pay yourself any profit, then you are not a candidate for S-Corp, and you seriously need to take a long, hard look at your business’ finances.
Those businesses bringing in over six figures are the best candidates, but even some of them are not profitable and can’t afford to pay themselves a reasonable salary. IF you are not bringing in a profit above a reasonable salary, then there is ZERO advantage to filing as an S-Corp.
But, but, but…
I KNOW. Those TikTok people are telling you something different. They’re promising the moon. Most don’t even tell you about the salary part – it’s all distributions. If they do mention the salary, then they urge you to take a micro salary, which is even worse because that shows you know the requirement to take the salary.
What’s worse is the tax professionals who lead you astray on S-Corps. I had a new client last year – a multi-million dollar realtor – who had filed as an S-Corp for YEARS. Two red flags: her commissions were paid to her personally and not to the S-Corp (big problem) and she’d never taken a salary. Her tax return had been prepared for those years by a CPA that I personally know. She hasn’t been audited…yet. In another case, I talked to a new client whose prior preparer (another CPA) had pushed her into an S-Corp. She wasn’t making ANY profit. In fact she was losing money, but the CPA was able to increase their fee substantially.
I’ve had many clients come to me because someone in their life had told them they needed to be an S-Corp. In most cases, that was a mistake. Once you’re an S-Corp, it’s not easy to go back to being a Sole Prop. You can do it, but it’s not easy.
The majority of S-Corps I consult with are not taking a salary or don’t have a profit to take a salary from, are not keeping bookkeeping records, don’t have basic financial statements, are not keeping their business and personal finances separate, don’t track their shareholder basis (another IRS requirement), and misunderstand the way deductions work for an S-Corp. The ones that choose to keep doing it wrong because they haven’t been caught yet are not a fit for me and my practice. The government is putting increased pressure and liability on tax pros for clients who do not follow the law. I’m not putting my license at risk for clients who insist on listening to social media influencers and breaking the law. If you’re teachable and committed to following basic ethics and law, then I’m happy to work with you.
How to Elect S-Corp status
If you decide that your business will benefit from S-Corp status, you will file form 2553 with the IRS, requesting to elect that status. Forms filed between Jan 1 and March 15 are automatically approved for that tax year. So forms filed by March 15, 2024 will apply to next year’s filing of your 2024 taxes. Be sure to submit a new W9 to any organizations that will send you a 1099. The new W9 will have your business name and EIN number. All payments must be made to the BUSINESS and not to you personally.
Late Election
It is possible to elect S-Corp status for the current tax year by filing Form 2553 and requesting a late election. You can file this form with your 1120S tax return for the current tax year. This is not an automatic acceptance and the IRS may or may not approve the status. They will also take a LONG time to let you know. You will be unable to efile a tax return until the acceptance has been made; however, you may mail a paper return and cross your fingers. By filing a Late Election, you are telling the IRS that you did, in fact, operate as an S-Corp for the current tax year, including taking required payroll.
Bottom (For Real) Line
Filing as an S-Corp CAN be a good way to save potentially large amounts of tax, but ONLY for businesses that are able to take the savings AND are willing to follow the rules and regulations.
The Fine Print
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. IRS Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in the entries in this blog (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
