I have no idea what an S-corp is anD at this point I’m too afraid to ask
Are all your friends talking about S-corps and you feel left out? Or maybe you set one up but don’t really know what to do with it? If you’ve got questions or just a feeling of anxiety around S-corps, then we’ve got answers for you!
What do I need to know about my S-corp? - Here’s the TL:DR
S-corps can often be a way to reduce the overall amount of taxes the business and owner pay, but they’re not a one-size-fits-all solution
Owners providing services for the business are required to take “reasonable compensation” via payroll (more below)
S-corps are a pass through entity (PTE), so the taxes on what the business earns are paid by the owners (with some exceptions discussed below)
Some states/cities impose additional taxes on S-corps that offset much of the federal tax savings
What is an S-corp anyway? - An S-corp is a corporation that has elected with the IRS to be taxed in a special way. Like a corporation, it has shares, shareholders and employees, but like an LLC, it is a “pass through entity” meaning that the S-corp doesn’t pay any tax* but instead the owners pay the tax on what the business earns. There are some limits on what type of entities can become S-corporations, but most owner operated businesses easily meet the requirements. There’s even a way to have an LLC taxed like it was an S-corporation, so for the purposes of this page, when I say “S-corp” I mean any entity that has elected to be taxed like an S-corp and when I say LLC, I’m referring to an LLC that hasn’t made that election.
I’m just here for tax savings, how does that work? - First, we need to talk about what taxes you are paying as a self employed person. We all know “income taxes” which are what most people think of when we’re talking taxes, but there are also social security and medicare taxes (collectively referred to as the Federal Insurance Contribution Act, or “FICA” taxes). When you work at a job for someone else, they withhold a bunch of taxes from your checks. Some of that is income tax, but some of it is also these FICA taxes at 7.65%. In addition to what you pay, your employer matches those FICA taxes (paying in an additional 7.65%) for a total of 15.3% FICA tax paid on all your wages. When you're a self employed individual with an LLC, partnership or no entity at all (this is called a sole proprietorship), you are both the “employee” and the “employer” so you get to pay that full 15.3% on all your earnings on top of your regular income tax rates, lucky you!
OK so I’m paying a bunch of taxes, how does the S-corp help with that? Unlike LLC’s, partnerships and sole proprietorships, the owners of an S-corporation DO NOT pay that FICA tax on the profits of the business! That’s a pretty big savings when compared with the other entity types.
So I don’t have to pay any FICA taxes at all? Not so fast! When the owners of the S-corporation also work IN the business (e.g. doing the work your clients want done) then they become employees of the corp in addition to being owners! You (the owner) get to take your profits without paying the FICA taxes, but you (the employee) has to pay FICA taxes on your wages, just like a regular employee does!
OK then, I’ll just pay myself a really small salary and take most of the money as profits! Believe it or not, the IRS is smarter than that. They have established a concept called “Reasonable Compensation” which means that if the owners of the S-corp are providing services to the business, then they are required to be paid as an employee for that work as if they were an unrelated person of comparable skills and value to the business. While there are always facts and circumstances, we’ve often found that our owner operated S-corp clients owners wages fall between 50% and 75% of the net profits of the business.
OK well saving tax on some of my income is better than none at all right? Yes, but while the S-corporation wins when it comes to saving on FICA taxes, there are some other areas where it come with increased costs, notably:
Despite their pass through status, some states and localities impose additional taxes on S-corps! notably NYC which charges a 8.85% tax which eats up a lot of the tax savings!
S-corps must file quarterly payroll returns even if they have no non-owner employees, where LLC’s and sole props without other employees don’t have to, and owner wages are subject to unemployment taxes.
S-corps require an additional tax return, more careful planning and as such will incur more accounting fees.
LLC’s and partnerships can end up with a larger QBI deduction than S-corps, which offsets some of the FICA savings.
Wow that sounds like a PITA! Am I really saving anything after all of those costs? Maybe, maybe not. For taxpayers with a net profit of 50-200K that aren’t in a locality with extra taxes on S-corps, they’re still a great entity choice. For taxpayers in NYC and other places with high local taxes on S-corps, the total tax picture ends up being about the same between the S-corp and a single member LLC, but the LLC is easier to administer which is why we’ll recommend it.
I already have an entity, should I switch to another entity type? Maybe, maybe not. In most cases where the S-corp isn’t a clear win over the LLC, it’s still pretty close, so we don’t often recommend that clients change their entity type unless there’s material savings, and we expect the circumstances for the next few years to support that level of savings for long enough to make it worth it.
IMPORTANT P.S.A.! Deciding whether to be an S-corp isn’t something you should do after reading a random page on the internet, it’s something you should discuss with your CPA who is factoring all of your unique circumstances. While we hope this guide is helpful to give an overview, please reach out to us before taking any action!