Please note that I am not a tax professional or accountant, some of this information could be wrong, and you should always consult a qualified professional about your unique circumstances.
If you're based in the US, you might have heard about "filing taxes as an S corporation" and been told that it can save you significant amounts of tax. While that is partly true, lowering taxes through an S corp comes with quite a few caveats and complications.
In this post, I'll break things down so you can understand the pros and cons a little easier, when it might make sense to file as an S corp, and when it might not.
As a TL;DR:
If you earn more than around $65,000 - $70,000 a year, filing as an S Corporation could save you a few thousand dollars a year in taxes. If you earn less than that, the extra complications, paperwork, and lower tax savings probably mean it's not worth it.
Buckle up buddies, because there's plenty of math ahead!
It's important to note that in most cases, you will not create an S Corporation itself, instead you just choose to file taxes as one. This is an important distinction. If you choose to actually create an S corp out of whole cloth, there's a ton of (non-tax related) corporate overhead, like issuing share certificates, holding minuted meetings, etc. You don't want that!
Instead, if you just want to file taxes as an S Corp, you need to:
An S Corporation reduces taxes in just one way - by lowering the amount of self-employment tax you pay. It has no impact at all on the amount of federal or state income taxes you pay. You lower the self-employment tax burden through:
This is the big one. The IRS states that as an S Corp officer (which is effectively what you are for tax purposes) you must pay yourself a "reasonable salary." This is to avoid the "Pay myself $10K as a salary, take out $40K in distributions, and avoid all of that SE tax" shenanigans.
Now, the IRS does not offer a ton of guidance on what a "reasonable salary" might be, apart from saying it should be equivalent to what you would pay someone else to do your role.
So, what would a "reasonable salary" be for your position? That's a good question - and one you can answer by looking at Glassdoor at the average salary for someone in your position. For example, I am a freelance writer, and Glassdoor shows ranges between around $35K and $55K a year. So, I might peg your salary at $45K.
My accountant also recommends that your salary be at least 50% of all your profits, because that's quite likely to be one of the thresholds the IRS uses to decide whether to audit you. So, if you're bringing in $100K after expenses, you'd want to set your salary at a minimum of $50K. Of course, you can (theoretically) set your salary wherever you want - just be aware that this could invite an IRS audit, and if they believe it's too low, you could need to pay more tax, together with penalties and interest.
FWIW, my LLC employs two people, me as a full-time writer and my wife as a part-time editor. Our combined salary is around $70K. We'll take in around $120K after expenses this year, allowing for $50K in distributions, or savings of around $7.5K.
Alright, that sounds good, but it's still not that straightforward, as there are lots of additional costs involved with filing as an S Corp that's going to dig into those tax savings.
Filing as an S corp requires you to jump through a few extra hoops, and those hoops all have a cost associated with them! I've used approximate amounts in all cases.
Payroll services (cost of $500 - $600 a year)
Firstly, you will need to pay for a payroll service. These services will calculate all of the taxes etc. on your payroll, allow you to add in benefits like 401(K) contributions, health insurance, etc. and move money between your business and personal accounts as part of paying yourself.
If they are a "Full-service payroll" (which is what you should look for), they will also, most importantly, file all of the relevant paperwork with the IRS and your state Department of Revenue (DOR). These services also generate a W2 at the end of the year, and other payroll-related tax forms that you might need.
You can use services like Gusto, Patriot, or similar, or even one built into your bookkeeping software (I use Wave, and they have a built-in payroll service.) Expect to pay around $40 - $50 a month for this service, about $500 - $600 a year.
FUTA and SUTA taxes (cost of $300 a year)
You will also need to pay a couple of new taxes, called FUTA and SUTA. These taxes are only levied on your salary amount, but depending on your state, you can expect them to come to around $300 or so a year.
Accountant (cost of $800 - $1,300 a year)
You will need to hire an accountant to help you prepare the relevant tax returns. Filing as an S Corp is not as simple as using TurboTax to file a 1040 with Schedule C. Instead, S corps require extra reporting, specifically filing a Form 1120S with the IRS and an equivalent form with your state DOR.
This form contains quite a bit of information like owner equity, business balance sheet, etc that you wouldn't normally provide on a 1040. That's why you need an accountant. Expect to pay around $500 - $800 for their help with an 1120S, and add on another $300 - $500 if they're also prepping your 1040 with those figures. So, that will be an extra $800 - $1,300 a year in accountant services.
Loss of "Qualified Business Income" tax deduction (cost of $1,000 - $1,500 a year)
LLCs can currently take advantage of Qualified Business Income (QBI) on all of their profits. QBI gives them a 20% deduction on those profits, which reduces the taxable basis for federal income tax. As an example, in a regular LLC, if you have $50,000 in profits, then QBI reduces your taxable basis by 20% of that, or $10,000.
Now, that does not mean you pay $10,000 less in income taxes, what it does mean is that your taxable basis is reduced, and it works very similarly to a standard deduction - your income is counted as lower for your tax band and how much you're taxed. For example, if your income tax is in the 12% band, the QBI would save you $1,200 (12% of the $10,000 QBI) in a year.
Here's the thing - S corps cannot apply QBI to salary payments - so they lose that tax saving. The QBI is still applied to distributions though. What does that mean in real terms? We'll use my income as an example:
We take in $120K a year after expenses. If we were filing taxes as a regular LLC, we'd get a QBI deduction of $24,000, which, with us being in a 12% tax band (our AGI is low enough for this due to retirement contributions) mean we would save around $2,900 a year in tax.
But, we pay ourselves a salary of $70K a year, that we do not get the QBI deduction on. That means our QBI deduction only applies to the $50K we take out in distributions, so it reduces our taxable basis by only $10,000. On a 12% income tax band, that means only $1.2K in tax reduction, so we "lose out" on $1.7K in tax savings.
Now, there are some "tricks" to avoid some of these costs, like only running one payroll at the end of the year, so you don't need to spend on a payroll service through the year, but those come with issues too. If you only run a $40,000 payroll at the end of the year, then in January you'll be on the hook for all of those taxes on that $40K, so you'd need to find $10K to $12K in taxes due in January - which could cause significant cash flow issues.
OK, so the extra yearly costs (approximate) from having an S corp are:
So, as you can see, S Corps are not the enormous money-saving frameworks that many people promise. Yes, they can save you some amount on your taxes, but there are additional costs you need to take into account.
S corps also need more attention from you as a business owner. Specifically:
So, if we make some assumptions about overall earnings, salaries, extra costs, etc., here's roughly how much you might spend / save as an S corp, based on paying a "reasonable salary" on the greater of $40K or 50% of earnings and fixed (non-QBI) extra S Corp costs of $2K.
Earnings
Salary
Distr.
QBI Loss
Fixed Costs
Tax saving
Total
$50,000
$40,000
$10,000
-$960
-$2,000
$1,530
-$1,430
$60,000
$40,000
$20,000
-$960
-$2,000
$3,060
$100
$70,000
$40,000
$30,000
-$960
-$2,000
$4,590
$1,630
$80,000
$40,000
$40,000
-$960
-$2,000
$6,120
$3,160
$100,000
$50,000
$50,000
-$1,200
-$2,000
$7,650
$4,450
$120,000
$60,000
$60,000
-$1,440
-$2,000
$9,180
$5,740
$140,000
$70,000
$70,000
-$1,880
-$2,000
$10,710
$7,030
So, as mentioned at the beginning, S corp filing starts to make sense at around $70K in earnings, provided you can stomach the extra admin! If you earn more than that, it's definitely something to think about.
Phew! That's it! I hope this has given you some helpful insight into S corporations, and whether they're worthwhile as a tax-saving option for your business.
Please note that all of these calculations are approximate, and don't take into account things like employer-portion write-off of SE tax amounts, S Corp health insurance premiums, tax write-offs, etc. All of this info is for illustrative purposes only, and you should always talk to a qualified professional about whether an S Corp is a good choice for you. I could be wrong about everything!
If you're based in the US, you might have heard about "filing taxes as an S corporation" and been told that it can save you significant amounts of tax. While that is partly true, lowering taxes through an S corp comes with quite a few caveats and complications.
In this post, I'll break things down so you can understand the pros and cons a little easier, when it might make sense to file as an S corp, and when it might not.
As a TL;DR:
If you earn more than around $65,000 - $70,000 a year, filing as an S Corporation could save you a few thousand dollars a year in taxes. If you earn less than that, the extra complications, paperwork, and lower tax savings probably mean it's not worth it.
Buckle up buddies, because there's plenty of math ahead!
How do I create an S corporation?
It's important to note that in most cases, you will not create an S Corporation itself, instead you just choose to file taxes as one. This is an important distinction. If you choose to actually create an S corp out of whole cloth, there's a ton of (non-tax related) corporate overhead, like issuing share certificates, holding minuted meetings, etc. You don't want that!
Instead, if you just want to file taxes as an S Corp, you need to:
- Create an LLC - you can do this yourself, or (my recommendation) do it through a company formation service like Incfile, LegalZoom, Rocket Lawyer, or any of the many similar services out there.
- You then need to file Form 2553 with the IRS. You can do this yourself or do it through the company formation service when you create your company.
- If you already have an LLC, then you can file a Form 2553 at the start of any year afterwards to get S Corp status.
- You need to file a Form 2553 within two months and 15 days of either forming your company or the start of the year, to be counted as an S Corp for that calendar year. The IRS will write to you when you have your tax status changed.
How does an S corporation lower my taxes?
An S Corporation reduces taxes in just one way - by lowering the amount of self-employment tax you pay. It has no impact at all on the amount of federal or state income taxes you pay. You lower the self-employment tax burden through:
- Dividing your earnings between paying yourself a salary and taking out money as a distribution.
- You do pay self-employment taxes (called payroll taxes in this particular instance) on the salary you pay yourself.
- You do not pay self-employment taxes on the distribution part (which you do if you're just a regular LLC, sole prop, etc.)
- The self-employment tax rate is 15.3% on all of your earnings (revenue less expenses), so this can work out to be a pretty good saving.
- You invoice $100K a year as a business and have $50K in expenses, leaving you $50K in profit.
- If you're a regular LLC, sole-prop or similar, you pay self-employment tax on the whole of that $50K, so around $7.7K.
- But, if you file as an S Corp, you might take a salary of $20K, (this is a bad idea, explained below) that you pay self-employment tax on, about $3K, but you don't pay self-employment tax on the remaining $30K that you take out as distributions, saving you around $4.5K.
You must pay yourself a "Reasonable Salary"
This is the big one. The IRS states that as an S Corp officer (which is effectively what you are for tax purposes) you must pay yourself a "reasonable salary." This is to avoid the "Pay myself $10K as a salary, take out $40K in distributions, and avoid all of that SE tax" shenanigans.
Now, the IRS does not offer a ton of guidance on what a "reasonable salary" might be, apart from saying it should be equivalent to what you would pay someone else to do your role.
So, what would a "reasonable salary" be for your position? That's a good question - and one you can answer by looking at Glassdoor at the average salary for someone in your position. For example, I am a freelance writer, and Glassdoor shows ranges between around $35K and $55K a year. So, I might peg your salary at $45K.
My accountant also recommends that your salary be at least 50% of all your profits, because that's quite likely to be one of the thresholds the IRS uses to decide whether to audit you. So, if you're bringing in $100K after expenses, you'd want to set your salary at a minimum of $50K. Of course, you can (theoretically) set your salary wherever you want - just be aware that this could invite an IRS audit, and if they believe it's too low, you could need to pay more tax, together with penalties and interest.
FWIW, my LLC employs two people, me as a full-time writer and my wife as a part-time editor. Our combined salary is around $70K. We'll take in around $120K after expenses this year, allowing for $50K in distributions, or savings of around $7.5K.
Alright, that sounds good, but it's still not that straightforward, as there are lots of additional costs involved with filing as an S Corp that's going to dig into those tax savings.
Extra costs associated with being an S corp
Filing as an S corp requires you to jump through a few extra hoops, and those hoops all have a cost associated with them! I've used approximate amounts in all cases.
Payroll services (cost of $500 - $600 a year)
Firstly, you will need to pay for a payroll service. These services will calculate all of the taxes etc. on your payroll, allow you to add in benefits like 401(K) contributions, health insurance, etc. and move money between your business and personal accounts as part of paying yourself.
If they are a "Full-service payroll" (which is what you should look for), they will also, most importantly, file all of the relevant paperwork with the IRS and your state Department of Revenue (DOR). These services also generate a W2 at the end of the year, and other payroll-related tax forms that you might need.
You can use services like Gusto, Patriot, or similar, or even one built into your bookkeeping software (I use Wave, and they have a built-in payroll service.) Expect to pay around $40 - $50 a month for this service, about $500 - $600 a year.
FUTA and SUTA taxes (cost of $300 a year)
You will also need to pay a couple of new taxes, called FUTA and SUTA. These taxes are only levied on your salary amount, but depending on your state, you can expect them to come to around $300 or so a year.
Accountant (cost of $800 - $1,300 a year)
You will need to hire an accountant to help you prepare the relevant tax returns. Filing as an S Corp is not as simple as using TurboTax to file a 1040 with Schedule C. Instead, S corps require extra reporting, specifically filing a Form 1120S with the IRS and an equivalent form with your state DOR.
This form contains quite a bit of information like owner equity, business balance sheet, etc that you wouldn't normally provide on a 1040. That's why you need an accountant. Expect to pay around $500 - $800 for their help with an 1120S, and add on another $300 - $500 if they're also prepping your 1040 with those figures. So, that will be an extra $800 - $1,300 a year in accountant services.
Loss of "Qualified Business Income" tax deduction (cost of $1,000 - $1,500 a year)
LLCs can currently take advantage of Qualified Business Income (QBI) on all of their profits. QBI gives them a 20% deduction on those profits, which reduces the taxable basis for federal income tax. As an example, in a regular LLC, if you have $50,000 in profits, then QBI reduces your taxable basis by 20% of that, or $10,000.
Now, that does not mean you pay $10,000 less in income taxes, what it does mean is that your taxable basis is reduced, and it works very similarly to a standard deduction - your income is counted as lower for your tax band and how much you're taxed. For example, if your income tax is in the 12% band, the QBI would save you $1,200 (12% of the $10,000 QBI) in a year.
Here's the thing - S corps cannot apply QBI to salary payments - so they lose that tax saving. The QBI is still applied to distributions though. What does that mean in real terms? We'll use my income as an example:
We take in $120K a year after expenses. If we were filing taxes as a regular LLC, we'd get a QBI deduction of $24,000, which, with us being in a 12% tax band (our AGI is low enough for this due to retirement contributions) mean we would save around $2,900 a year in tax.
But, we pay ourselves a salary of $70K a year, that we do not get the QBI deduction on. That means our QBI deduction only applies to the $50K we take out in distributions, so it reduces our taxable basis by only $10,000. On a 12% income tax band, that means only $1.2K in tax reduction, so we "lose out" on $1.7K in tax savings.
Now, there are some "tricks" to avoid some of these costs, like only running one payroll at the end of the year, so you don't need to spend on a payroll service through the year, but those come with issues too. If you only run a $40,000 payroll at the end of the year, then in January you'll be on the hook for all of those taxes on that $40K, so you'd need to find $10K to $12K in taxes due in January - which could cause significant cash flow issues.
How all of these costs add up
OK, so the extra yearly costs (approximate) from having an S corp are:
- Payroll: $500 - $600
- FUTA and SUTA: $300
- Accountant $800 - $1,300
- Loss of QBI deduction: $1,000 - $1,500
- For a total of: $2,600 to $3,700.
So, as you can see, S Corps are not the enormous money-saving frameworks that many people promise. Yes, they can save you some amount on your taxes, but there are additional costs you need to take into account.
S corps require more administration
S corps also need more attention from you as a business owner. Specifically:
- You will need to run your payroll on a regular basis (e.g. each month), and take account of benefits, contributions, and deductions for things like health insurance premiums, 401(K) amounts, etc.
- Taxes on payroll (SE tax, state, federal income tax) are normally due the month following you running payroll, so you need to bear that in mind.
- You'll still need to pay estimated taxes (federal and state income tax) on your distribution amount, four times a year.
- You will need to register for SUTA and FUTA taxes.
- Accounting is a bit more complicated, in that you'll need to read, review, and understand the 1120S before approving it for filing.
When is an S corp worth it?
So, if we make some assumptions about overall earnings, salaries, extra costs, etc., here's roughly how much you might spend / save as an S corp, based on paying a "reasonable salary" on the greater of $40K or 50% of earnings and fixed (non-QBI) extra S Corp costs of $2K.
Earnings
Salary
Distr.
QBI Loss
Fixed Costs
Tax saving
Total
$50,000
$40,000
$10,000
-$960
-$2,000
$1,530
-$1,430
$60,000
$40,000
$20,000
-$960
-$2,000
$3,060
$100
$70,000
$40,000
$30,000
-$960
-$2,000
$4,590
$1,630
$80,000
$40,000
$40,000
-$960
-$2,000
$6,120
$3,160
$100,000
$50,000
$50,000
-$1,200
-$2,000
$7,650
$4,450
$120,000
$60,000
$60,000
-$1,440
-$2,000
$9,180
$5,740
$140,000
$70,000
$70,000
-$1,880
-$2,000
$10,710
$7,030
So, as mentioned at the beginning, S corp filing starts to make sense at around $70K in earnings, provided you can stomach the extra admin! If you earn more than that, it's definitely something to think about.
Phew! That's it! I hope this has given you some helpful insight into S corporations, and whether they're worthwhile as a tax-saving option for your business.
Please note that all of these calculations are approximate, and don't take into account things like employer-portion write-off of SE tax amounts, S Corp health insurance premiums, tax write-offs, etc. All of this info is for illustrative purposes only, and you should always talk to a qualified professional about whether an S Corp is a good choice for you. I could be wrong about everything!