When an S corp election starts to pay

Owners hear about the S corp election from a friend, usually with a number attached. The number is real for some businesses. For others, the costs quietly eat it. Here's how to tell which you are.

What changes

As a sole proprietor or partner, all your profit is subject to self-employment tax, which funds Social Security and Medicare. An S corporation splits your income in two. You pay yourself a salary through payroll, which carries the same payroll taxes. The rest of the profit passes to you as a distribution, which doesn't. That difference is the whole saving.

A reasonable salary

The IRS expects owner-employees to pay themselves a reasonable salary for the work they do before taking distributions. Reasonable means roughly what you'd pay someone else to do your job. A very low salary is the classic mistake, and it's one the IRS looks for.

The saving comes from the profit above a fair salary. No profit above it, no saving.

The real costs

An S corp runs payroll every pay period, even if you're the only employee. It files its own return, Form 1120-S, by March 15, with a K-1 for each owner. Your books need to be clean and current, because salary, distributions and expenses must be kept apart. Some states also charge their own fees or taxes. Add these up before you compare.

A worked example, in words

Picture a consultant whose business makes a steady profit year after year, and who would pay someone a little over half of that profit to do the same job. As an S corp, the salary carries payroll taxes just as before. The part above it doesn't carry self-employment tax. Against that saving go the cost of payroll, a second return and tighter bookkeeping. When the profit above a fair salary is small, those costs can be larger than the saving.

Questions to ask first

Is your profit steady, or did one good year make it look bigger than it is? Would you rather keep the simplicity of one return? Are you planning to take on investors? S corps allow only one class of stock and limit who can own shares, which matters if you plan to raise money.

Timing the election

You elect with Form 2553. To have it apply for a calendar year, file it in the previous year or within two months and fifteen days of the start of the year, so by March 15. Relief for late elections exists in some cases, but it's far easier to decide in the autumn. That's why we run the numbers in our October review, while there's still time to act.