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.
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.
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. 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.
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.
Tyler Murray, Murray & McCarthy Law
We often refer clients to Tyler Murray in Denver. He’s a former chair of the Tax Law Section of the Colorado Bar Association, holds an LL.M. in Taxation, and helps business owners form their companies and handle the legal issues that come up afterward. mmcoloradolaw.com
Talk with us first so you know whether the numbers work, then let the attorney build it right.