S-Corporations: Pros & Cons
Updated: Oct 27, 2022
One of the most common questions I get are about S-Corporations (S-Corp) and if it's actually worth it to be in one. S-Corps can provide some easy tax savings, especially if combined with other strategies. S-Corps are also one of the first things I consider when looking at businesses that are profitable but don't yet have a strategy in place. However, it's important to consider all the pros as well as the cons to be sure an S-Corp is right for you.
There are many things to consider before electing to be taxed as an S-Corp, here are the Pros & Cons to help you decide if the pros outweigh the cons.
Potential Tax Savings
The main benefit of being taxed as an S-Corp is the possibility of tax savings. Tax saving are achieved by taking the tax code and using it to your advantage. The biggest advantage of S-Corporations compared to Single Member LLCs (SMLLC) is that S-Corps are not subject to self employment tax. This means that income earned in an S-Corp is taxed less compared to the same income if it was received through a SMLLC or Sole Proprietorship. The catch is that businesses taxed as a S-Corp are required to pay themselves a "Reasonable Wage", we will talk more on this in the Cons section.
Dividing Income is Easy
For tax purposes, dividing income is easy when it comes to S-Corps. By law, there can only be one class of stock. Income, expenses and distributions must be divided equally among the shareholders based on ownership percentages. This makes things easy when estimating income for members of S-Corps because you can divide income based on ownership percentage.
There are many added cost associated with operating an S-Corp, starting with bookkeeping requirements. Bookkeeping becomes more important with S-Corps due to the increased need for detailed records. It's still possible to manage the books of an S-Corp yourself but odds are the time requirement to manage your own books may not be worth the sacrifice.
Electing to be taxed as an S-Corporation comes with the added requirement to file an additional return each year with the IRS. Form 1120-S is due each year along with corresponding state returns (depending on your state). Not ever tax professional has the knowledge to comply with the additional filing requirements and not every DIY tax service has the capability to file as well. This means you can expect to pay more for tax preparation services each tax season.
As mentioned earlier, one of the added requirements of S-Corporations is paying yourself a reasonable wage. This means that you will need to either file payroll tax returns yourself or seek the services of a payroll company such as ADP, Paychex or Gusto.
Calculating a Reasonable Wage
The catch of not being subject to self-employment tax is the requirement to pay yourself a reasonable wage. S-Corporations with wages too low run the risk of audit from the IRS and possibly could be subject to wage recharacterization, the act of the IRS changing previously tax-free distributions to taxable wages, defeating the main reason for the election in the first place. On the other side, wages set too high increase unnecessary taxes due to payroll taxes. A solid strategy with S-Corporations should always include a reasonable compensation study to determine an amount that is neither too high or too low. A compensation study should be done periodically to assure the wage amount is up to date.
Reasonable Compensation Studies are included in every subscription service we offer. You can be sure that your wages are set at an appropriate level to avoid both IRS scrutiny and unnecessary taxes.
Expenses May Outweigh Tax Saving
Due to the numerous added costs, it's very possible that the added cost to run and maintain a S-Corporation could negate any tax savings achieved by making an election. It's also very possible that the added expenses cost more than the tax saving and could be catastrophic for your business.
As you can see, there is more to consider then just the tax savings associated with S-Corporations. It's important to be sure a S-Corporation is right for you before making an election. To be sure a S-Corporation is right for you and your business, seek the guidance of a tax professional.
We specialize in helping business make the savvy move when it comes to S-Corporations. If you would like to learn more about how we can help your business create, implements and maintain and effective tax strategy in your business, schedule an online consultation today. Consultations are no cost and no commitment.
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