S Corporations (Form 1120-S)

It’s one of the most common questions we get from self-employed clients, and the honest answer is: it depends on how much you make. An S corporation can save real money, but only when the business earns enough. Below that level, the extra cost and paperwork eat the savings, and sometimes more.

What an S corporation actually is

An S corporation isn’t a different kind of business. It’s a tax election. You form an LLC or a corporation with the state, then file Form 2553 with the IRS asking to be taxed under Subchapter S. The business itself generally pays no federal income tax. The profit passes through to you on a Schedule K-1 and is reported on your personal 1040, much like it is now on Schedule C.

Where the savings come from

As a sole proprietor, you pay self-employment tax of about 15.3% on nearly all of your net profit. That’s Social Security and Medicare, both the employer half and the employee half, paid by you.

With an S corporation, you become an employee of your own company. You pay yourself a salary through payroll, and Social Security and Medicare apply only to that salary. The rest of the profit comes to you as a distribution, which isn’t subject to those taxes. That difference is the main benefit of an S corporation, and for most small businesses it’s the only one that matters.

The catch: you must pay yourself a reasonable salary

You can’t set your salary at $10,000 and take everything else as distributions. The IRS requires S corporation owners who work in the business to pay themselves reasonable compensation, meaning roughly what you’d have to pay someone else to do your job. The IRS has won case after case where owners took too little salary, and the courts reclassified distributions as wages, with back taxes, interest, and penalties. A defensible salary is the foundation of a sound S corporation.

What it costs to run one

An S corporation comes with ongoing obligations that a Schedule C doesn’t have. You’ll file a separate corporate return (Form 1120-S), due March 15, a month before your personal return. You’ll run payroll, make monthly payroll tax deposits through EFTPS, file quarterly Form 941s, issue yourself a W-2 every January, and pay federal and Colorado unemployment taxes and Colorado FAMLI premiums on your wages. You’ll also keep your business finances fully separate and track your stock basis from year to year.

Between return preparation, payroll, and these added taxes, figure on roughly $2,000 to $3,000 a year in extra cost. Missing a payroll deposit is expensive. Payroll tax penalties are some of the steepest the IRS charges.

Where it starts to make sense

Here’s a rough comparison at three income levels. The shaded band is the added cost of running an S corporation. A bar has to clear the band before you come out ahead.

Yearly savings before added costs

Single owner, reasonable salary as shown, 20% qualified business income deduction, 22% federal bracket. Your numbers will differ.

Net business income	Salary	Social Security and Medicare saved	Extra income tax (smaller QBI deduction)	Savings before added costs
$60,000	$35,000	$3,100	$1,800	$1,300
$100,000	$50,000	$6,500	$2,800	$3,700
$150,000	$65,000	$11,200	$3,900	$7,400

Subtract $2,000 to $3,000 in added costs, and the picture is clear. At $60,000, an S corporation loses money. At $100,000, it starts to pay for itself. At $150,000, it’s well worth doing.

That’s why our general guideline is that an S corporation makes sense once your Schedule C net income is consistently above about $100,000. We don’t recommend setting one up for a business earning less than that. We see too many small business owners who were sold an S corporation, paid a setup fee, and have been paying for extra returns and payroll ever since, with no benefit to show for it.

The trade-off people don’t hear about

Paying less into Social Security now means a smaller Social Security check later. Your benefit is based on your lifetime earnings subject to Social Security tax, and S corporation distributions don’t count. For someone close to retirement, or someone who will rely heavily on Social Security, this deserves a real conversation, not just a calculation.

Other things worth knowing

Who can own it matters

S corporations are limited to 100 shareholders and one class of stock. Owners must generally be U.S. citizens or residents, estates, or certain trusts. Partnerships, other corporations, and nonresident aliens can’t be shareholders, and transferring shares to one will end the election. A few details that matter in practice: a husband and wife (and their estates) count as one shareholder, as do all the members of a family going back six generations, so the 100 limit is rarely the problem; a living trust whose grantor reports its income can hold the stock, and so can a trust set up for one beneficiary or an estate for a reasonable time after a death, but a trust that does not fit one of the permitted types must file its own election (a QSST or ESBT election) within two months and 15 days or the S status is gone; and “one class of stock” is about the rights to distributions and liquidation proceeds, not voting — voting and nonvoting shares are fine, and so is a shareholder loan on ordinary commercial terms that would otherwise look like a second class.

Health insurance works differently

If you own more than 2% of the company, health insurance the company pays for you goes on your W-2. It’s generally still deductible on your personal return, but it has to be set up correctly through payroll.

Losses are limited

If the business loses money, you can deduct the loss only to the extent of your basis in the company, meaning what you’ve invested and lent to it plus prior undistributed profits. You’ll file Form 7203 with your return to track this. Two points trip people up. First, a bank loan you guaranteed gives you no basis, because you have not put money in; only a loan you actually make to the company does, and if the company repays it while your basis in the loan is reduced, part of the repayment is income. Second, losses that exceed your basis are not lost; they carry forward and are deductible when you restore basis, including by making a loan to the company before year end. A shareholder who wants a loss this year can often get it by lending the money in December.

Timing matters

To be an S corporation for the whole year, Form 2553 is generally due by March 15 for a calendar-year business, or within two months and 15 days of starting a new company. For a new company the clock starts on the earliest day it has shareholders, owns assets, or does business, so a corporation formed on January 10 has until March 24 of that year, not March 15. Every person who owns stock on the day the form is filed must sign it, and so must anyone who owned stock earlier in the year if the election is to be effective for that year. Late elections can often be fixed, but it’s better to get it right the first time.

Getting out is easier than getting back in

If an S election is revoked or terminated, you generally can’t re-elect for five years. A voluntary revocation needs the consent of shareholders holding more than half the stock; filed by the 15th day of the third month of the year, it takes effect for the whole year, and filed later it takes effect the following year unless a specific date is chosen. When a termination happens mid-year, the year is split into a short S year and a short C year, and the income is divided between them by the day unless everyone agrees to close the books on the termination date.

Fringe benefits are taxed like a partner’s

A shareholder who owns more than 2% is treated like a partner for fringe benefits, not like an employee. Health, disability and long-term care premiums, group-term life insurance, meals and lodging furnished for the company’s convenience, and contributions to a health savings account or a cafeteria plan all have to run through the owner’s W-2. Retirement plan contributions, working-condition fringes and educational assistance still work the same as for any employee. This is one of the few places where a C corporation does better by its owner.

Making the switch from a Schedule C

Most S corporations start as a sole proprietorship or a one-member LLC that outgrew it. The path depends on which one you have.

If you already have an LLC

One form. An LLC that is eligible files Form 2553 and, by doing so, is treated as having elected to be taxed as a corporation and then as an S corporation on the same date; no separate Form 8832 is needed. The election can be made effective on the first day of a year or, for a new LLC, on the day it started, as long as the 2553 is filed within two months and 15 days of that date. Nothing changes at the Colorado Secretary of State; the state doesn’t recognize the S election at all, and your LLC stays an LLC.

If you are a sole proprietor with no entity

Three steps, in order. First, form the entity with the Colorado Secretary of State — an LLC, in practice, or a corporation with articles, bylaws and stock. Second, get the entity its own EIN, bank account and payroll account; the proprietorship’s EIN does not carry over. Third, file Form 2553 within two months and 15 days of the earliest day the new entity has owners, owns anything, or does business. Miss the window and the late-election relief under Rev. Proc. 2013-30 is available for three years and 75 days, with a reasonable-cause statement, but it is far easier to file on time.

Moving the business in

The assets of the proprietorship — equipment, the truck, inventory, receivables, the customer list — are contributed to the new company in exchange for its stock or membership interest. Under §351 that transfer is tax-free as long as you get only stock back and own at least 80% of the company afterward, which a single owner always does. The company takes your basis in each asset (carryover basis) and your holding period; depreciation for the year of the switch is split between the Schedule C and the 1120-S by the date of transfer; and your basis in the stock starts at the basis of what you put in, minus any liabilities the company took over. Write the transfer down — a bill of sale or a contribution agreement listing each asset and its basis, kept in the corporate book — because the §351 treatment and your starting basis both depend on being able to show it. Put in enough that the company isn’t thinly capitalized: your basis is what lets you deduct a loss in a bad year and take distributions tax-free in a good one.

Before you do it: can you run a corporation?

The S election is only as good as the bookkeeping behind it. An S corporation needs a separate bank account that personal expenses never touch, a set of books that balances to that account, payroll run on time, minutes of an annual meeting even if the meeting is you at the kitchen table, and written loan agreements for any money moving between you and the company. These aren’t IRS rules so much as the price of the liability protection; a creditor who can show the company and its owner were never really separate can ask a court to ignore the corporation. A year or two of clean Schedule C books before switching is the best preparation.

Your first year as an S corporation: the checklist

We wrote this for new S corporation clients after watching the same things get missed. The quarterly payroll returns are the ones that matter most; penalties on payroll deposits are the steepest the IRS charges, and they start the first month a deposit is late.

The federal calendar

The Colorado calendar

The decisions to make up front

• Set your salary for the year and run it the same every pay period. A reasonable salary first, the rest as distributions. Decide the number in January, not December; see the reasonable salary rule above.
• Open EFTPS before the first payroll. Enrollment takes a week or two by mail. Set the deposits to come out automatically each month.
• Health insurance through the company. If the company pays or reimburses your premiums, they go in box 1 of your W-2 (not boxes 3 and 5) and you deduct them on your 1040. If they don’t go through payroll, the deduction is lost.
• Retirement plan. A SEP contribution is based on your W-2 wages, not the K-1, and is the company’s deduction on the 1120-S. A solo 401(k) usually allows more at the same salary.
• Track your basis from day one. What you put in, plus each year’s K-1 income, minus distributions and losses. Form 7203 goes with your 1040 whenever there is a loss, a distribution, or a loan repayment, which is every year for most owners.
• Keep distributions proportional if there is more than one owner, and keep loans between you and the company in writing. Unequal distributions can be read as a second class of stock.
• Business expenses you pay personally get reimbursed by the company under a written accountable plan — mileage at 72.5 cents for 2026, the home office, the phone. An owner can no longer deduct unreimbursed employee expenses on the 1040.
• Pay the 941 before the 1040-ES. If cash is short, the payroll deposit comes first: it is trust-fund money, the penalties are personal, and the estimate can be caught up.

And the trade-off again, because it is the one clients come back to: the salary you choose is also the amount Social Security will credit you with for the year. Less in now, less out later.

The bottom line

An S corporation is a tool, not a status symbol. If your business is netting $100,000 or more and you’re prepared to run payroll and keep clean books, it can save you thousands of dollars a year. If you’re earning less, a Schedule C is usually the simpler and cheaper choice. Call us at 303-734-1040, and we’ll run the numbers on your actual situation before you spend a dime on setup.

Setting it up right is a legal job, too

Whether an S corporation is right for you often depends on legal questions as much as tax ones. Should you form an LLC or a corporation? Who will own it, and in what shares? If there’s more than one owner, what happens when one wants out, retires, or dies? How do you keep the liability protection you’re paying for?

These decisions are made once, at the start, and they’re hard to undo. An operating agreement or buy-sell agreement written the wrong way can create a second class of stock or put shares in the hands of someone who isn’t allowed to own them, and either one can end your S election. A properly formed company, with the right agreements in place from day one, protects both your tax savings and your personal assets.

That’s why we recommend having an attorney handle the formation. We handle the tax side, including the S election, payroll setup, and your returns. The legal structure belongs with a lawyer who knows business and tax law.

Talk with us first so you know whether the numbers work, then let the attorney build it right.

Call Tax Shop: 303-734-1040

← Back to all tax topics