Let’s clear up the confusion on S-Corps!
What is an S-Corp?
An S Corporation (S-Corp) is a special type of corporation that provides significant tax advantages over LLCs and sole proprietorships. However, these benefits come with stricter reporting and compliance requirements, such as bookkeeping and payroll obligations. The tradeoff becomes well worth it once a business reaches a certain level of profitability.
The primary advantage of an S-Corp is that distributions (profits taken out of the business by shareholders) are not subject to self-employment tax. However, there’s a catch—any S-Corp owner who actively works in the business must pay themselves a reasonable salary before taking distributions. In other words, if you’re both an owner and an employee, you must be on payroll and the salary must be realistic.
Failing to elect S-Corp taxation and remaining an LLC could cost you thousands of dollars in unnecessary taxes each year. Think of an S-Corp as a “leveled-up” LLC—it’s ideal for business owners who have grown their companies, are consistently profitable, and want to optimize their tax savings.
Who Should Switch to an S-Corp Election?
If your business generates at least $40,000–$50,000 in annual net profit, it’s likely time to consider switching to an S-Corp election. Many LLC and sole proprietorship owners reach this level of profitability but aren’t aware they should make the switch—a mistake that costs them thousands in unnecessary taxes each year.
Let’s break down why.
One of the biggest drawbacks of operating as an LLC or sole proprietorship is that 100% of your profits are subject to self-employment tax, which is 15.3%.
With an S-Corp, you only pay self-employment tax on your salary (reasonable compensation). Any additional profits you withdraw as distributions are not subject to the 15.3% self-employment tax.
Self-employment tax consists of two components:
Social Security Tax of 12.4%
Medicare Tax of 2.9%
Thus the total Self-Employment Tax is 15.3%.
This tax is in addition to income tax, making it a significant expense.
Example: LLC vs. S-Corp Tax Savings
Let’s say your business earns $50,000 in net profit:
LLC/Sole Proprietor: Pays 15.3% on the full $50,000 → $7,650 in self-employment taxes
S-Corp (with $30,000 salary & $20,000 distribution): Pays 15.3% only on $30,000 salary → $4,590 in self-employment taxes
Tax Savings: $3,060 per year
As your profits increase, these tax savings grow even more.
How to Elect S-Corp Status
To become an S-Corp, a Tax Professional will file Form 2553 with the IRS by March 15 of the year you want the election to take effect. If you miss this deadline, the election will apply to the next tax year—unless you qualify for late election relief.
The best time to switch to S-Corp taxation is January 1, ensuring clean accounting and tax reporting for the full year.
Bookkeeping: A Must for S-Corps
If you elect S-Corp status, organized bookkeeping is non-negotiable. A mistake here can lead to IRS scrutiny, missed tax savings, and financial headaches.
✔ Use Accounting Software: Implement QuickBooks Online or another accounting system to track income and expenses.
✔ Hire a Professional: A credentialed bookkeeper can ensure accuracy, compliance, and maximize your tax benefits.
✔ Don’t DIY It: Many business owners assume they can manage their own books, but errors can be costly. A CPA or bookkeeper will save you time and stress.
I provide bookkeeping services for current S-Corps and businesses looking to transition. If you or someone you know needs S-Corp bookkeeping, reach out to me!
Payroll: Don’t Skip This Step
Since S-Corp owners must take a salary, setting up payroll correctly is critical. Failure to do so can result in IRS penalties and defeat the purpose of switching to an S-Corp.
Make sure you do the following:
✔ Use Reliable Payroll Software: I recommend QuickBooks Payroll or Gusto for smooth payroll processing.
✔ Run Payroll Regularly: Ensure payroll is processed on time, withholding taxes properly.
✔ Avoid Common Mistakes: Some S-Corp owners forget to set up payroll or run it inconsistently, which can lead to compliance issues.
Again, hiring a bookkeeper to manage payroll ensures that everything runs smoothly and correctly.
You might be wondering how do you determine “reasonable compensation” — ie: how much in payroll should you be taking every year.
The IRS considers multiple factors when determining if an S-Corp owner’s salary is reasonable, including:
Industry Standards – What is the typical salary for similar roles in your industry and location?
Duties & Responsibilities – The extent of the owner’s involvement in the business (management, client work, operations, etc.).
Experience & Qualifications – An owner with extensive experience or specialized skills should have a higher salary.
Time & Effort – Full-time owners should receive a higher salary than those who only work part-time.
Company Revenue & Profitability – If the business is highly profitable, the salary should reflect that.
Compensation of Non-Owner Employees – The owner’s salary should be in line with what a non-owner would be paid for the same job.
Historical Compensation – If the owner’s salary is significantly lower than in prior years while profits and distributions increase, the IRS may see it as tax avoidance.
If the IRS determines that an S-Corp owner is underpaying themselves to avoid payroll taxes, they may:
Reclassify distributions as wages, subjecting them to payroll taxes and penalties.
Assess back taxes, penalties, and interest for unpaid payroll taxes.
Increase IRS scrutiny on the business, potentially leading to audits.
While the IRS doesn’t specify a fixed formula, a common rule of thumb is to pay at least 40-60% of total business profits as salary before taking distributions. However, this can vary depending on your industry and role.
Final Thoughts
Choosing an S-Corp can be a game changer for business owners looking to reduce taxes and increase profitability. If your business earns at least $40,000–$50,000 in net profit, switching to an S-Corp could save you thousands in taxes each year.
Need help determining if an S-Corp is right for your business? Consult with a professional to analyze your specific situation and ensure a smooth transition.
Let’s Connect!
If you need S-Corp bookkeeping or payroll services, I can help! Shoot me a message, and let’s ensure your finances are set up for maximum tax savings and compliance.
