The S-Corporation can be a very powerful tool in your tax planning life. However, it is important to realize that there is a proper time to use this tool. Below a certain income level, it does not make sense to take on the additional reporting requirements of the S-Corporation. Along with possibly providing an extra layer of protection for the businesses owner, you often can reduce your overall tax liability because the net income is not subject to the self-employment taxes (don’t be too excited yet – you will have to pay yourself a salary).
Although the tax savings can be a huge plus for the S corporation, there are additional filing requirements. These include an additional tax return (the 1120S), payroll filing requirements (even for the shareholders), and a more complex personal tax reporting situation. Keep in mind that if you later decide that the S corporation is not for you (and you revoke the status), you will either have to shut down the business or be taxed as a C Corporation (usually unfavorable) for at least 5 years. However, it can be worth it!
One of the first important things you should do is determine if it is the right time to be taxed as an S Corporation. If you make the decision too soon, there could be additional reporting requirements with very little or no tax savings. However, if the decision is made too late, there could be savings left on the table.
Generally speaking, I advise clients to start considering the S Corporation when the net income will be about $40,000 to $50,000. Although there is no exact science to the decision, this is generally where you will see significant savings to make up for all of the extra costs and reporting requirements.
The main reason to be taxed as an S Corporation is to legally avoid paying additional self-employment taxes. For illustration purposes, we will assume that the net income of your business will be $100,000. As a sole proprietor or active partner in a partnership, you will have to pay $15,300 in social security and Medicare taxes. If your net income of the S corporation is $60,000 with a $40,000 salary, you will only have to pay $6,120 in Social Security and Medicare.
Cons of the S Corporation
Although there can be significant tax savings with the S Corporation, it does not come without additional headaches and requirements. If you choose to be taxed as an S corporation, there is an additional tax return to be filed (the 1120S) instead of filing on your Schedule C.
This will be more complex and often bring about a higher fee from your CPA. Also, you will be required to pay a reasonable salary to any active shareholders. Due to the complexity of the payroll laws and regulations, a payroll service will most likely be required. However, if the savings are significant, the additional requirements will be worthwhile!
The S Corporation can assist you in paying less overall taxes (due to the net income not being subject to self-employment taxes). With overall income (before salary to the shareholder) of around $40,000 to $50,000, there could be some serious savings. In the end, these tax savings can allow you to grow your business and save for the future.
Keep in mind that if you later decide that the S Corporation is not for you, you will either have to dissolve the business or be taxed as a C Corporation for at least 5 years. This is often not favorable for the business. It is important to discuss all of the advantages and disadvantages of changing your tax methods with your trusted tax advisor. I look forward to discussing all of the pros and cons of the S Corporation.