Tax Tuesday
5 Reasons To Set Up a Small Business S Corp (and 5 related problems)
Set up an LLC, tax as an S Corp. That’s the common refrain. Let’s dig into the second part of that suggestion.
One of the very first decisions you have to make when starting a business is the organization type. Based on my totally non-scientific polling (a.k.a. talking to people in my networking groups), there’s a popular belief that most individuals starting their endeavor should jump right into the Small Business S Corp.
I thought that for a while, too! There is good reason the S Corp remains extremely popular among small business owners.
But just because everyone’s jumping from that entity cliff doesn’t mean that it’s the right one for you. So rather than give the typical “look at the amazing savings!” typically posted about S Corp, I thought it’d be more helpful to give the reasons why you what to use one, plus the reasons they might not be so good.
Oh, and if you’re running that business from home, S Corp or not, don’t forget to check out my 7 Home Office Tax Deductions Considerations.
Let’s dive in.
What is an Small Business S Corp?
At the simplest level, an S Corp is a Corporation taxed following the laws of Subchapter S of the Internal Revenue Code.
Popular media likes to paint corporations as some of Satan’s loveliest spawn (see: Continuum, The Outer Worlds, The Warehouse, etc), but it’s really just one of a handful of ways to organize your business efforts (though I have no comment on what sort of evil you might do with it once you set it up).
S Corps are organized so the business owner pays taxes on income, rather than the company. With our current tax law, this typically means lower overall taxes, but it comes with limits to what you can do.
Limits that are aimed to focus it as a tool for small(er) businesses.
Hence it’s often known as the Small Business S Corp.
Okay, enough introduction. Let’s get onto the good stuff.
Good Reason #1: Payroll Tax Break
You can’t talk about the Small Business S Corp without talking about payroll taxes.
Anyone who has ever worked a job for a paycheck has, at some point, looked at their paystub and wondered, “Who the heck is FICA, and why is he taking all my money?”
That FICA stuff is your payroll taxes. As an individual, 7.65% of your income is withheld to pay for the twin government behemoths of Social Security and Medicare. The company matches your payment for another 7.65%.
For indiepreneurs and solopreneurs, that means YOU are paying the full 15.3%. So 15.3% of every dollar you earn goes to Uncle Sam, before even considering income taxes.
For some people, that can be the difference between being able to start your business and being stuck working for one of those evil corporations.
Using an S Corp can potentially save some money on those payroll taxes.
This can be confusing without getting to much in the weeds, but at a high level it works like this: without the S Corp, a self employed individual has to pay payroll taxes on ALL their earnings. As an S Corp, the corporation pays the shareholder/employee a paycheck (yes, even if is a company of one). ONLY the amount on the paycheck is subject to payroll taxes.
Let’s play this out with an example.
EXAMPLE TIME: Billy is a musician who sells samples to producers. During the year, he nets $50,000 of income. His payroll taxes without electing an S Corp would be approximately $7,650.
If, however, he put that business through an S Corp, he would have more flexibility. He decides only 50% of that income should go to his salary, or $25,000. That means his payroll taxes would only be about $3,825, a significant savings.
How did Billy come up with 50% of the earnings going to salary? More on that in the “bad” section.
Why This is a Problem: What’s a Reasonable Salary?
To get the most out of the payroll tax reduction benefit, you have to pay yourself a low salary.
The IRS, on the other hand, wants you to have a high salary. This is specifically to stop you skipping on payroll taxes.
The law answers this difference by saying you have to pay yourself a “reasonable” salary.
What’s a reasonable salary?
Heck if I know.
I’ve heard people say, “Oh, as long as you pay x amount of salary, you’ll be fine!” And you may be! But the fact of it is that the IRS doesn’t give guidance on that.
You’ll have to do your best to come up with a number. Then you’ll have to pray that the IRS agrees if they audit you.
Another Reason this is a Problem: Additional Payroll Forms
For independent contractors and sole practitioners not going the S Corp route, payroll taxes will all be factored in on your annual 1040. No separate filings necessary.
Easy.
Well, easy-ish.
If you run an S Corp, you are an employee, so you’ll have to file extra employee forms. You’ll have to send yourself a W-2. You’ll have to file the related W-3. Then there’s the payroll withholding done on 940 and 941.
And that doesn’t even count whatever your state may require.
None of those forms are particularly hard, but it is another thing to do.
Good Reason #2: Still get the QBI Deduction
A big part of the 2017 TCJA tax reform was to lower taxes for big corporations to make their tax rate more competitive globally.
Small business, including small business S Corp, were none too please that this made their taxes potentially higher than what the big corporations were paying.
In an attempt to fix this discrepancy, Congress added the Qualified Business Income Deduction, which allowed an additional 20% deduction for small businesses. This would keep their taxes lower than the big companies.
The QBI deduction calculation can get really complicated, but the basic rule is that as long as the taxpayer earns less than around $158k if you’re single or $315k if you’re married filing jointly, S Corp earnings qualify for this deduction.
Why This is a Problem: Who knows if QBI will last
The great QBI Deduction will go away in 2025 if Congress doesn’t vote to renew it.
Considering Congress can’t seem to figure out what it’s doing next week, much less years down the line, it’s hard to count on that deduction being renewed.
Good Reason #3: Separate Tax Return
An S Corp needs to file a separate tax return (Form 1120S). Yes, even though the tax ultimately appears on your 1040.
Having a separate return is good, for both practical and legal reasons. If someone legally has the right to see your business return, do you really want to give them your full personal return?
Likely not. I know I don’t.
Why This is a Problem: Harder to Prepare
As hard as it is to believe, the individual income tax returns are actually relatively easy to prepare.
I know, right? My Income Tax students certainly don’t all agree.
The 1040 is theoretically designed so non-professional tax preparers can file them. Even if a lot of it gets messy thanks to Congress layering rule upon rule.
The S Corp form doesn’t have that same design in mind. It’s still doable without professional training, especially for smaller S Corps. But it’s not intuitive.
Also, it’s just another thing to do when what you really want to do is get to work.
On the plus side, there is still a TurboTax for S Corps if you really want to do it yourself.
Better yet, hire a professional.
Good Reason #4: Fixed Structure Reduces Need for Lawyers
If you’re doing this business thing alone, skip this section.
For those doing business with a cohort, read on.
You and your business associate need to set up a structure to make sure you’re both fairly rewarded. Unless you’re in Silicon Valley, that means either a Partnership or an S Corp.
An S Corp provides very structured rules. Every S Corp follows them. They have to, or it won’t be allowed to be an S Corporation anymore.
This can be good, since it means that there’s less confusion and disagreement of who gets what. If Billy has 50% of the company and Hughie has 50%, then they get exactly 50% each of the profits and losses.
This saves a lot of potential legal hassle. Especially compared to pulling up a Partnership Agreement on LegalZoom without realizing the tax implications.
Why This is a Problem: No ownership flexibility
On the flipside of that same point, the Small Business S Corp offers no flexibility into the ownership structure. Maybe you don’t want Hughie to control 50% of the company. Maybe he gets 50% of the profits, but only 5% of the power.
I mean, him and Annie, right? Who knows if you can trust him.
If you want to get into complicated structures, an S Corp is absolutely NOT the way to go.
Good Reason #5: Add an LLC for easier set up and additional protection
Limited Liability Companies, or LLCs, are all the rage these days. This is a state level business organization that allows a business to have some liability protection in case of lawsuits without getting into a lot of the complications of other entity types.
These have their own (mostly cost) related drawbacks, but let’s not get into that here.
The good thing is that you can set up an LLC in your state, then file a simple Form 2553 with the Feds to create your S Corp.
BONUS Problem: Potentially Not As Good For Selling
This is typically just a Silicon Valley concern, but a few others may be interested. If you start a business and believe you’ll be the next Pied Piper, an S Corp is not the way to go.
Instead, you’d do a C Corp. When you sell, setting it up right can get you a really nice Small Business Stock Gains exclusion. This allows you to make a whole ton of money without having to pay taxes on a bunch of it.
I worked with a number of small companies in San Jose who believed they were going to sell to Google for millions (or billions). For them, an S Corp didn’t even enter into their mind.
Outside of the valley, most people people don’t care about this exception. They just want to do what they love and make enough money to let them do it.
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