Owners ask us about the S-corp election more than any other planning question, usually because someone told them it saves tax. It can, but it also adds work and cost, and for some businesses it doesn’t come out ahead. This post covers how the two set-ups are taxed, so you can see where the difference comes from.
As a sole proprietor
If you run the business in your own name, or through a single-member LLC that hasn’t made an election, the business’s profit goes on Schedule C of your personal return. You pay income tax on that profit, and you also pay self-employment tax on it, which is the Social Security and Medicare tax an employer would otherwise share with you. Self-employment tax applies to your net earnings from the business whether you take the money out or leave it in the account.
The set-up is simple. There’s no payroll to run for yourself, and there’s no separate business income tax return.
As an S-corp owner who works in the business
An S-corp is a tax election, made on IRS Form 2553, by a corporation or an LLC. Once it’s in effect, the business pays you a salary through payroll. Social Security and Medicare tax are withheld from that salary and the business pays its matching share, the same as for any employee.
Profit left after your salary can be paid to you as a distribution. Distributions aren’t subject to Social Security and Medicare tax. That is where the saving comes from: part of the profit is no longer subject to those taxes. Income tax still applies to all of it, salary and distributions alike, on your personal return.
The IRS expects the salary to be reasonable for the work you do. Paying yourself a very small salary to move everything into distributions is the pattern the IRS looks for, so we set the salary from what the job would pay someone else.
What the election costs to run
Running the business as an S-corp means:
- payroll for yourself, with quarterly payroll returns and a W-2 at year end
- a separate federal return for the business (Form 1120-S), and a K-1 to carry the results onto your personal return
- a Virginia return for the business as well as your own
- more bookkeeping, because the business’s accounts need to be kept apart from yours and reconciled
Those costs are the same whether the business has a good year or a slow one. The saving depends on profit. So the election tends to pay off when profit is consistently well above what a reasonable salary for your work would be, and it can cost more than it saves for a business that’s just starting or has uneven years.
When to look at it
Look at it before the start of the year you want it to apply to. There’s a deadline for making the election each year, and missing it means extra paperwork or waiting a year.
We work this out from your own figures as part of tax planning: last year’s profit, what this year looks like, what a reasonable salary for your role would be, and the added cost of payroll and the extra returns. If the numbers don’t support the election yet, we’ll say so and tell you what would change that.