Many business owners are looking for effective ways to reduce their corporate tax burdens. If you fall into this category, you may have heard that becoming an S-Corp is a great way to achieve that goal. 

But should you become an S-Corp to save on taxes? 

There are several things to consider before making this move. First, you should understand what an S-Corp is, its benefits, and its disadvantages.

What is an S-Corp?

An S-Corp is a corporation that passes corporate income, deductions, losses and credits to their shareholders for tax purposes. The shareholders then report that flow-through income or losses on their personal tax returns. Taxes are assessed at individual income tax rates.

The S-Corp structure helps businesses avoid double taxation on corporate income. After all, S-Corps are still required to pay tax on certain gains and passive income.

Becoming an S-Corp does have advantages, but there are also some disadvantages to consider.

What are the Benefits of Registering as an S-Corp?

The primary advantage of forming an S-Corp is the potential tax savings. 

For a corporation without the S-Corp designation:

  • The corporation would be taxed for its income, AND
  • Every partner will also be taxed when their income is paid out 

With the S-Corp status, the business can avoid this double taxation. 

How about if your business is operating as a sole proprietorship, single-member LLC, or a partnership? 

For individuals who operate a sole proprietorship, a single-member LLC (that hasn’t elected to be treated differently), or a partnership, the net earnings from the business are typically subject to self-employment tax, which is currently 15.3%

But as an S-Corp, profits can be disbursed to owners as distributions. These distributions aren’t subjected to employment-related taxes such as Social Security or unemployment insurance. Only the wages earned by the owner as an employee are liable for payroll taxes. More on this below.

While S-Corp owners get to bypass the self-employment tax, they are required to make themselves W-2 employees of the corporation. Here, the IRS will require that you pay yourself a reasonable salary.

The IRS considers several factors when determining whether an officer’s wages are reasonable, including but not limited to:

  • Training and expertise
  • Dividend history
  • Time and effort dedicated to the business
  • Responsibilities
  • What other similar businesses are paying for similar services

You must continue to pay yourself and other S-Corp owners an officer’s wage in order to remain compliant with IRS regulations. Failing to comply with this rule can result in hefty fines and penalties against the corporation. Always consult with your CPA on what is a reasonable salary for you. 

What are the Disadvantages of an S-Corp?

If an S-Corp sounds great to you and you’re thinking, “why wouldn’t I register as an S-Corp,” there are disadvantages to consider. You may not want to make the transition because of the following:

  • Stricter documentation: Your S-Corp will have additional costs involved. Recordkeeping is stricter, you must adhere to meeting requirements, and administration costs will rise. If you’re going from a sole proprietorship to an S-Corp, you’ll need to be prepared for more paperwork and costs to manage these documents.
  • Audit risks: On top of the paperwork that you must fill out, the IRS will also monitor your business more closely. The IRS will monitor your S-Corp to ensure that you pay yourself an acceptable salary. If you fail to meet this requirement, you may owe substantial penalties and interest.
  • Eligibility: Your company may not meet S-Corp eligibility requirements. For example, if you have over 100 shareholders, you’re ineligible. Additionally, all of the shareholders must be US residents. 
  • Retirement: Your retirement options may be impacted if you take more dividends, which means that you may not be able to leverage a tax-advantaged IRA plan.

Certain states may not recognize an S-Corp, and this is something else to consider. Additionally, you can end up in a very complex situation if you cannot meet salary obligations.

Is an S-Corp Right for Your Business? 

Maybe. It’s easy to say that if you reach a certain amount of revenue, an S-Corp is a great option. But there are times when the conversion doesn’t make sense. For example, one client of mine had over a million in yearly revenue, but they didn’t have the cash to pay themselves the required salary.

You should take the time – or work with someone like us – to run the numbers for you. We’ll work through the numbers to learn if the tax benefits and requirements to become an S-Corp are worth it. 

If you meet the criteria below, it’s worth having a conversation to see if an S-Corp is right for you:

  • You want the advantage of a corporation but still want pass-through taxation
  • Reducing your self-employment tax is your goal
  • You have the revenue and cash flow for an S-Corp to make sense
  • You have fewer than 100 shareholders, all of whom are US residents.

Be sure to speak with a professional before taking the leap and electing as an S-Corp.

Final Thoughts

An S-Corp is beneficial for some business owners and not others. You need to weigh the pros and cons of registering as an S-Corp and make your decision carefully. While most states will allow you to convert back to an LLC, you may need a conversion plan.

If you have a board of directors, you’ll also need their approval before the conversion is allowed.

Are you considering registering as an S-Corp but don’t know if it’s the right choice for you?

Click here to schedule an appointment to have us review your financials and determine if electing an S-Corp is in your best interest.

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