These days, one of the most common questions I get asked about business finance is, “Should I form an S corp?”
Simple time tracking that syncs with payroll.
S corps are like the latest indie movie to take over Twitter. It’s got the buzz, your friends say you definitely have to go see it, but every time you watch the trailer you can’t figure what the movie’s really about.
Do S corps really live up to the hype? Even though everyone else is forming one—should you? How do you know if it’s really worth the time and investment?
The truth is every business is different. Just like our taste in movies, just because everyone else loves something doesn’t mean that you will. Forming an S corp is a decision that you should make with consideration and care.
While you should always consult a legal and financial advisor about your legal structure, there are some early questions you can ask to see if you’re ready to consider forming an S corp.
How does an S corp work?
If you haven’t heard of S corps yet, here’s a brief rundown of how they work. Like sole proprietors and partnerships, S corps are pass-through entities. That means all of the business income is passed through to the owner of the company, and they report the income on their personal tax return.
Unlike sole proprietors, LLCs, and partnerships, however, the income passed through from an S corp is not subject to self-employment tax, which amounts to 15.3%. The owner only pays income tax on their business’s income.
I know this is super exciting and you’re probably bouncing out of your chair right now—but hold up. There’s something else you need to know.
S corps are required to pay their owners a “reasonable compensation” through payroll. That means that you, the owner, will be an employee of your business.
Your business will pay FICA payroll taxes (7.65% of your salary) and you personally will pay FICA taxes (7.65% of your salary), which is withdrawn from every paycheck. In other words, you are paying the equivalent of self-employment tax on your salary.
How much you pay yourself depends on your industry and tax strategy, but you do have to pay yourself. If not, it looks like you’re abusing the S corp taxation structure and using it to avoid paying self-employment tax on your business income.
If you are paying yourself a reasonable compensation (which, by the way, is a tax deduction for your business), whatever profit your business makes is not subject to corporate taxation or self-employment tax. And that’s where S corps really shine.
How do you know if you’re ready for an S corp?
Alright! Now that you know how this entity works, here are four things to ask yourself:
1. Can your business cover the additional costs?
When you form an S corp you have additional monthly and annual costs. Before forming an S corp make sure that you can pay for these costs.
At the very least, every month you’ll have to pay for:
- Owner’s salary: This amount will vary depending on how much you decide to pay yourself.
- Payroll taxes: FICA taxes are 7.35% of your annual salary. FUTA taxes are 6% on the first $7,000 that you earn.
- Payroll processing fees: The cost varies by the payroll provider, but you can expect to pay at least $45 per month.
Annually, you may have additional costs related to:
- Tax preparation fees: Your S corp will now need to file its own tax return, the 1120-S, and you will still need to file a personal tax return.
- Annual state fees: Most states require that you pay an annual fee for your business entity. The fees vary state by state and range from $10 to $800.
You could also have additional costs related to:
- Bookkeeping and accounting: S corps are under more scrutiny by the IRS. That means your bookkeeping should be up to date and accurate. You may also want to hire an accountant to help you set your salary and develop a tax strategy for your business.
- Insurance: Some states require businesses operating as a corporation to carry certain types of insurance. Additionally, some insurance rates may go up based on your entity structure.
Finally, you will also have the cost of forming your S corp, which includes state filing fees and legal fees if you’re using a legal filing service.
2. How much taxable income do you have?
One of the primary reasons business owners form S corps is because of the tax savings potential. However, not everyone benefits from forming an S corp.
In some cases, the cost of forming an S corp, running payroll, and paying payroll taxes is more than what you’d save on taxes. Other times, after the expense of the owner’s salary, the business’s net income is so low that the tax savings are minimal.
So how much money do you need to make for an S corp to benefit you? To be honest, there’s a lot of opinions on this one. I’ve heard it range from $45,000 to $70,000 in taxable income (your business’s, not your own). Personally, I think if your business is making more than $60,000 in profit every year, then you should look into forming an S corp.
Keep in mind that we’re talking about taxable income, not gross revenue.
- Your gross revenue is all the money you make from your products and services.
- Your taxable income is your revenue minus your tax deductions. Essentially, it’s the profit from your business.
For example, if your revenue is $75,000 and you have $40,000 in expenses, your taxable income is $35,000.
If you were an S corp, a portion of this $35,000 would go to paying your “reasonable salary,” for instance $25,000 a year. So your numbers would look like this:
$75,000 (revenue) – $40,000 (operating expenses) – $25,000 (owner salary) – $2,346.50 (employer payroll taxes) = $7,653.50 (taxable income)
In this example, the taxable income of $7,653.50 is not subject to self-employment tax. However, because the taxable income is so low, the tax savings are minimal and may not outweigh the costs of an S corp.
Here’s how it compares to a sole proprietor:
|Sole Proprietor||S Corp|
|Employer Payroll Taxes||$0||$2,346.50|
|Employee Payroll Tax (deducted from paycheck)||N/A||$1,912.50|
|Total Payroll Taxes Paid||$4,945.34||$4,259|
In the above example, the payroll tax savings is only $686.34, which isn’t enough to warrant the additional costs of an S corp.
3. How consistent is your cash flow?
The most common struggle I see with newly formed S corps is that there isn’t enough cash flow to cover payroll. Remember, as an S corp, you’re not only paying the owner’s salary, you’re also paying payroll taxes.
On the employee side, your take-home pay is what’s left after your portion of taxes is withdrawn from your paycheck. That means that you may need to increase your salary or take an additional distribution to cover your living expenses.
Here’s an example of what I mean:
As a sole proprietor, you draw $4,000 out of your business every month to cover your living expenses.
As an S corp, you have a monthly salary of $4,000. Your business pays $306 in payroll taxes. Your business has to have enough cash to cover a $4,306 withdrawal.
You, the employee, also have $306 withdrawn from your paycheck plus federal and state tax withholdings. What you receive may be closer to $3,200.
To cover your living expenses you need to take an additional $800 distribution from your business. That means your business needs $5,106 in the bank to cover your monthly payroll costs and distribution.
What I see time and time again is that people start S corps before they have dependable cash flow. Then, they skip payroll runs and take distributions instead. The next thing they know the entire year has gone by without a single payroll run, which is a red flag for the IRS.
Before you start an S corp ask yourself: Do I have consistent cash flow to cover regular payroll runs? If the answer is no, you may not be ready for a Scorp.
4. Do your long-term business goals include investors or partners?
We’ve talked a lot about the financial side of forming an S corp and you may be thinking, “Yes! I’m ready.” But before you go all in, consider your long-term business goals:
- Where do you see your business three to five years from now?
- Do you plan on looking for investors?
- Do you foresee getting acquired by another business?
- Will you want to add a business partner?
These are important questions to ask yourself before forming an S corp.
S corps cannot have more than 100 shareholders, and only US citizens or permanent residents can be owners and investors. The allocation of S corp income or losses is based on stock ownership. In other words, if you own 50% of the S corp, you’re automatically allocated 50% of the business’s income.
This allocation happens regardless of whether you’ve paid out dividends to your shareholders. That means if you have a silent partner, they will be taxed on the business income based on the percentage of the business that they own. This is different than an LLC, which can allocate income and losses based on an operating agreement.
S corps can only have one class of stock. However, you can have voting and nonvoting stock, which helps widen the possibilities of bringing on additional owners. But it still makes working with investors trickier than a standard LLC—and you would need to hire a lawyer, adding to your costs.
Finally, an S corp cannot be owned by a corporation or a partnership. That means if another company wants to purchase your business, you will need to change your entity structure. This may also make it more difficult to find investors for your business.
Before forming an S corp, get clear on your long-term business goals. If they include investors and partners, an S corp may not be the right entity for you.
After answering these questions, if you think you’re ready for an S corp, consult a tax and legal advisor about your unique situation. Who knows? In just a few months you could be saving thousands of dollars on your taxes.