This article was derived from a livestream with Michelle Green and attorney Jennifer Brugh.
Every accountant, it seems, recommends that their clients form S Corporations. Whatever their business, whether they employ nobody or a staff of hundreds, it’s a common recommendation. So, is an S Corporation right for your business? It depends! The answer changes based on your expenses and the size of your company. Before we get there, however, we need to run through the basics.
What Is An S Corp?
An S Corporation is a United States tax election for a closely-held company. It is not a business structure, like LLC, partnership, corporation, etc. Since LLC, partnership, corporation, etc., are state designations and not tax elections, you can structure your business as one of those and also be designated as an S Corp for tax purposes. It’s not an either-or decision. For more information about the other business structures we mentioned, you can read about them on our website.
How Do They Work?
S Corps bear similarities to another tax election, the C-Corporation, and receive some of the same benefits. For example, S Corp owners are not held personally liable for the business. However, the IRS taxes them as a flow-through entity. This means that the tax liability falls directly on the individual members, or partners. Additionally, large corporations can elect C-Corps status but not S Corp status. S Corps are intended for smaller businesses. Businesses with sizes between “really small” and “really medium” fall in the sweet spot for businesses that will do best as an S Corp.
Here’s what we mean: because S Corps require you to pay yourself (have official payroll practices), really small business may find themselves unduly burdened by S Corp status. Payroll expenses and the time spent on the accompanying labor can add up. In addition, figuring out the salary requirement of an S Corp can be difficult. The regulations simply dictate a “reasonable salary”, which leaves a lot to interpretation. You’d want to pay yourself the least amount possible that still qualifies as “reasonable,” and then any of the business’s net income left over at the end of the year will flow to the owners as a distribution. However, several courts have weighed in on factors that can be used to determine “reasonable.” They included things like knowledge, experience, and what others in a similar field/position earn. The distributions are not subject to self-employment tax and instead are taxed as ordinary income. The salary you pay yourself is taxed as wages and therefore also not subject to self-employment tax.
Is An S Corp Right For Me?
To figure out if an S Corp is right for you, you’ll want to compare your overall tax liability in these two situations:
- How much do you pay in taxes between the self-employment tax and your ordinary income as a sole proprietorship?
- What would you pay in payroll taxes for the business as an S Corp (which, thankfully, are deductible), plus the actual expenses for doing payroll?
If you’d pay less in taxes and costs doing payroll as an S Corp and taxing your income from the distributions than you pay for the self-employment tax, then an S Corp might be a good fit. Your best bet is to reach out to an accountant or tax attorney and have them help you crunch these numbers.
What’s the downside of setting up an S Corp?
Of course, despite what you might hear, S Corps aren’t for everyone! They’re almost never good for small businesses. S Corps require a lot of formality.
As we mentioned, you have to pay yourself a “reasonable salary” and there’s not a lot of clear law on what “reasonable” means (prevailing wisdom defines it as what you would earn doing your position for someone else). You have to have bylaws for the S Corp, you have to actually hold regular meetings, and you have to keep minutes from those meetings. These are in addition to filing the informational return each year, which involves filing an 1120 along with issuing K-1s to your owners so that they can report their taxes. And you have to set up payroll processing.
Let’s face it, when you launch a business, you have no idea how those first few years are going to go. Immediately opting for S Corp status will put a lot more stresses and responsibilities on you as a business owner.
How Do I Become One?
If you decide to go for S Corp status, you simply need to file Form 2553 with the IRS. That form communicates some basic information about your business. You need to submit it within two months and 15 days from the start of your tax year for your election to go through. If your business is brand new, this timeframe starts the moment you incorporate. If you decide after years of operation to become an S Corp, this timeframe starts with the regular tax year. There are some ways around this if you miss a deadline, but you’d need an attorney to draft up a letter and the forms to plead your case and approval is not guaranteed.
Still have questions about how S Corps work or if they’re right for your business? You aren’t alone! We can help you make that assessment. Reach out today for a consultation, and read more on our website about forming an LLC or a PLLC.