When to use an S-Corporation

Aug 16, 2022

An S-Corp is a common entity to save on taxes and most small business owners should be using them as their entity of choice.

I consistently get asked by business owners around the country if an S Corporation is a good fit for their business and I can tell you that there is a lot at stake. So much so, that it is well worth your time to know the basic differences between an S Corp and LLC and be careful who you take advice from.

Surprisingly there are advisors across the country that miss the mark and give truly damaging advice that costs small business owners thousands of dollars!

You are the captain of your own ship! You need to be able to determine if your professionals are advising you under standard and well-recognized basic concepts.

LLC Taxed as an S-Corporation

An LLC ‘taxed as an S Corp’ is the same thing as a standard S Corp set-up as an ‘Inc’. The IRS considers them the same.

When you convert to an S-Corp (with a properly filed IRS Form 2553), your name won’t change with the State. You will still have the acronym ‘LLC’ at the end of your company name – and that’s OK!!

The main reason why business owners may start or begin their business with the LLC entity is so they can ‘convert’ to the S-Corp when the time is right. This is actually a very affordable process. Until the ‘election’ is made to convert, the LLCs is taxed as a sole proprietorship or partnership.

But Remember, an LLC (Limited Liability Company) doesn’t save taxes whatsoever!! That’s why we want to convert to the S-Corporation.

Benefits of an S Corporation

The main benefit of an S Corp is to honestly and ethically save on Self-Employment Tax (SE Tax). SE tax, also referred to as FICA, consists of Medicare and Social Security taxes totaling a 15.3% hit on your bottom line. In a sole prop or an LLC taxed as a sole prop, SE tax is applied to every dollar of net self-employment income reported on Schedule C or earned on a K-1 from a partnership.

For a lot of small business owners, FICA taxes can dwarf even federal income taxes, but this tax is often overlooked as mandatory and unavoidable. The S Corp is the solution.

In an S-Corp, net income is split into a salary portion and a pass-through or net-income portion. S-Corps are pass-through entities (just like LLCs); so all income earned in the S-Corp DOES NOT pay corporate tax and any income is taxable to the individual owners in the year earned and is subject to ordinary income tax rates. However, in an S-Corp SE tax is only applied to the salary, not on the net income. This means that for every thousand dollars you classify as pass-thru income, you save $150 in taxes!

Other benefits of an S Corp include:

  • asset protection,
  • the ability to contribute cost cefffectivly to a Solo 401k,
  • building of corporate credit, and
  • also have less chance of an audit.

That’s right! Estimates are that S Corps are 15x less likely to get audited than a LLC/Sole Proprietor, even though they save more in taxes!

So, why not classify all the income as dividends and take no salary? Because the IRS requires S Corps to pay owners a reasonable salary. 

Here are the 5 Factors that might make you a likely candidate for an S Corp:

1. Do you have income subject to Self-Employment tax?

The first question we ask clients to determine whether or not they need an S Corp is to understand if they have income subject to SE tax. Self-employment income is often referred to as ‘ordinary income’ derived from services or the sale of products.

It’s not income from a W-2. Examples of this type of income would be that of a realtor, broker, dentist, doctor, plumber, electrician, internet marketer, contractor, hair stylist, chiropractor, attorney, cpa, restaurant owner, manufacturer, import/exporter, real estate flipper, insurance agent, multi-level marketer, financial advisor, consultant, or anyone getting a 1099 Misc for self-employment income.

Passive income IS NOT subject to SE tax. Passive income is rental income, interest, dividends, capital gain, etc.

2. Are there restrictions on me operating as an S-Corp in my industry?

This question inevitably comes up in locales where licensing is required for your profession. Brokers, realtors, insurance agents, doctors, lawyers, and contractors all need to check with their local licensing boards to make sure they can operate inside an S-Corp with their license.

The answer is usually yes, but some jurisdictions will require the license to be held by the S-Corp or will require the business owner to jump through hoops to make this work. In one recent case, a client told me it was going to cost him over $5,000 to switch his licenses over to the S-Corp and could take months to complete.

If there are going to be significant hurdles to establishing your S-Corp, you will want to assess the ultimate tax savings and whether the benefit of the S-Corp outweighs the cost before making that decision.

3. How much income do I need before an S-Corp makes sense?

This is a critical question because a business owner doesn’t need or want to incur the cost of an S Corp unless the tax savings exceed the cost. We have generally advised our clients that the break-even point is approximately 40k in net income.

Otherwise stated, if your business is making net ordinary income subject to SE tax of 40k or more then you are a candidate for an S Corp. The reason why we feel this is the ‘break even’ point, is because of the salary/net-income allocation. We are careful and cautious to make sure payroll allocations are tailored to each business owner and their situation, but oftentimes there can be 2-3k in savings at this threshold.

Again, meet with an advisor that truly understands this strategy and is willing to be cautiously aggressive.

4. How will this affect my 199-A deduction?

The 199-A deduction is a product of the Tax Cuts and Jobs Act and gives small businesses an automatic 20% deduction on all pass-through income. The deduction can be subject to a phase-out calculation for professional service business owners with AGI over $157,500 for single filers and $315,000 for joint filers.

There is also another calculation that kicks in for non-professionals when they hit similar income levels. Bottom line, this is a wonderful deduction that is not inhibited by the S Corp, but actually enhanced with the strategy of the S Corp. A qualified tax advisor will help its business owner clients to find a balance between salary and net income to minimize SE tax and maximize the 199A deduction. It’s a huge opportunity for planning!

5. How much will an S-Corp cost me?

First, you have setup costs. This can range from $200 to $1,000 depending on the amount of consultation, support, and documentation provided by the law firm performing the service. We urge you to be cautious in this process. It IS NOT simply a ‘filing of articles’.

There are multiple documents that need to be included. Also, consulting and support are critical for a business owner new to the S Corp and need to understand the maintenance procedures. We charge either $400 or $800, plus the filing fee, for an S Corp in any State in the Country.

Next, you have the ongoing maintenance and the quarterly and annual tax filings. With an S-Corp you will be paying yourself a salary, so even if you don’t have other employees you will have to do payroll and file quarterly payroll reports with the IRS. The S-Corp also must file its own year-end tax return and issue you a W-2. These annual costs could range from $1500-$2000 depending on your situation.

This is why the ‘savings’ for an S Corp owner needs to be more than $2,000 before an S Corp makes ‘financial’ sense in the first place. Although the other reasons for asset protection, corporate credit, and audit risk reduction still may all make sense, it’s important to understand the financial situation before pulling the trigger.

Get a Consultation or 2nd Opinion

I am convinced after over 20 years of experience helping small business owners and our office supporting thousands of business owners, the S Corporation is ultimately the best entity for an operational business owner in the long run.

Don’t underestimate the power of the S Corp and get a second opinion if anyone says an S Corp isn’t the best fit. Ironically, we see more people avoiding the S Corp and being talked out of it by an uneducated advisor, rather than prematurely setting up an S Corp.

The attorneys in our office are all capable of helping you with this decision based on these factors and more. The cost of a consultation is much less than the cost of making a mistake and filing for the wrong entity!

* To sign up for Mark’s weekly Free Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.

Mark J. Kohler is a CPA, Attorney, co-host of the PodCasts “The Main Street Business Podcast” and “The Directed IRA Podcast”, and the author of “The Business Owner’s Guide to Financial Freedom- What Wall Street Isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”, as well as several other well-known books. He is also the CFO of Directed IRA Trust Company, and a senior partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP, and the accounting firm K&E CPAs, LLP.