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Should You Form an S Corporation?

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One of the most popular inquiries I hear regarding business finance nowadays is, “Should I form an S corp?”

S corps are like Twitter’s trendiest new movie. Your pals recommend it, but whenever you view the trailer, you need help figuring out what the movie is about.

does S Corp. deserve the hype?

Even though everyone else is making one, should you? 

How do you know if it’s really worth the time and effort?

Each company is different. You don’t have to choose something simply because everyone else does. Forming an S corporation is a choice that should be considered carefully.

Always consult legal and financial counsel about your legal structure. Some basic inquiries will help you decide if you’re ready to incorporate an S corporation.

But first…

how does an s corporation operate?

If you’ve never heard of S Corps, here’s a quick rundown of how they work. S corporations are pass-through entities like sole proprietorships and partnerships. That means all business income is passed through to the company’s owner, who reports it on their personal tax return.

However, unlike sole proprietorships, LLCs, and partnerships, revenue passing through from an S corp is not subject to self-employment tax, which is 15.3%. The owner solely pays income tax on the profits of their business.

We realize this is thrilling, and you’re probably jumping out of your chair right now—but wait. There’s something else you should be aware of.

S corporations must pay their owners “reasonable compensation” via Payroll. That means you, as the business owner, will work for your business.

Your company will pay FICA payroll taxes (7.65% of your salary), and you will pay FICA taxes (7.65% of your salary), which will be deducted from each paycheck. In other words, you pay the same amount of tax on your salary as if you were self-employed.

Your industry and tax strategy determine the amount you pay yourself, but you must pay yourself. If not, you are misusing the S-corp tax structure to avoid paying self-employment tax on your business income.

If you pay yourself a reasonable wage (which is tax-deductible for your business), any profit your company produces is not subject to corporation or self-employment taxation. And this is where the S Corps truly shines.

how do you know if you’re ready for an s corporation?

Alright! Now that you understand how this entity operates, here are four questions to ask yourself before creating your own business:

step 1: can your business afford the additional costs?

You incur additional monthly and annual expenses when you incorporate an S corporation. Make sure you can afford these charges before incorporating an S corporation.

At the very least, you’ll have to pay for the following each month:

  • The Owner’s Salary: This amount will vary depending on how much you decide to pay yourself.
  • Payroll Taxes: FICA taxes are calculated at 7.65% of your annual pay. FUTA taxes are 6% on the first $7,000 earned.
  • Payroll Processing Fees: The cost varies depending on the payroll provider, but you should budget at least $45 monthly.

You might have to pay additional charges each year for the following:

  • Tax Preparation Fees: Your S corporation must now submit its own tax return, the 1120-S, and you must still file a personal tax return.
  • Annual State Fees: The majority of states require an annual fee for your business entity. Fees vary state by state and can range from $10 to $800.

You may also incur additional expenses as a result of the following:

  • Bookkeeping and Accounting: The IRS scrutinizes S corporations more closely. That implies your bookkeeping must be current and correct. You may also wish to engage an accountant to assist you in determining your compensation and developing a tax strategy for your company.
  • Insurance: Certain types of insurance are required by some states for corporations operating as corporations. Furthermore, some insurance costs may rise depending on your organization’s structure.

Finally, the cost of forming your S corp will include state filing fees as well as legal fees if you use a legal filing service.

you may also like to read: business entities understanding the different types and their tax implications.

step 2. how much of your income is taxable?

One of the key reasons business owners form S corporations is to save money on taxes. However, not everyone benefits from the formation of a S corporation.

In some circumstances, the expense of incorporating an S corporation, conducting payroll, and paying payroll taxes is more than the tax savings. Sometimes, after deducting the owner’s salary, the business’s net income is so low that the tax savings are negligible.

So, how much money do you need to make to benefit from an S corp? To be honest, there are a lot of different points of view on this one. I’ve heard that it can range from $45,000 to $70,000 in taxable income (from your business, not your personal income). If your company makes more than $60,000 in profit annually, you should consider becoming an S corp.

Remember that we’re discussing taxable income, not gross revenue.

  • Your gross revenue is the total amount of money you make from your products and services. 
  • Your taxable income is the total amount of money you make minus your tax deductions. Essentially, it is your company’s profit.

For example, if your revenue is $75,000 and your expenses are $40,000, your taxable income is $35,000.

If you were an S corporation, a portion of this $35,000 would be used to pay your “reasonable salary,” say $25,000 yearly. So your numbers would be as follows:

$75,000 in revenue – $40,000 in operating expenses – $25,000 in owner salary – $2,346.50 in employer payroll taxes = $7,653.50 in taxable income.

In this case, the taxable income of $7,653.50 is exempt from self-employment tax. However, due to the low taxable income, the tax savings are limited and may not outweigh the costs of an S corp.

This is how it compares to being a sole proprietor:

Sole Proprietor S Corp
Revenue $75,000 $75,000
Operating Expenses $40,000 $40,000
Salary of owner $0 $25,000
Employer Payroll Taxes $0 $2,346.50
Taxable Income $35,000 $7,652.50
Self-Employment Tax $4,945.34 N/A
Employee Payroll Tax (deducted from paycheck) N/A $1,912.50
Total Payroll Taxes Paid $4,945.34 $4,259


In the preceding example, the payroll tax savings are just $686.34, which is insufficient to justify that why should have S Corp.

you may also like to read: how to find a competent tax advisor 

step 3: how stable is your cash flow?

The most prevalent issue I encounter with freshly formed S Corp. is a lack of cash flow to fund payroll. Remember that as an S corporation, you must pay payroll taxes in addition to the owner’s.

Your take-home pay is what remains after your percentage of taxes is deducted from your paycheck. You may need to increase your wage or receive an additional distribution to cover your living expenses.

you may also like to read: how much does it cost to start a business 

here’s an illustration of what I mean:

As a sole proprietor, you take $4,000 per month from your firm to cover your living needs.

You earn $4,000 every month as an S corporation. Payroll taxes cost your company $306 for each employee. Your company must have enough cash on hand to handle a $4,306 withdrawal.

You, the employee, have also had $306 deducted from your paycheck in addition to federal and state tax withholdings. What you get could be closer to $3,200.

You will need to take an additional $800 payout from your firm to cover your living expenses. That means you’ll need $5,106 in the bank to cover your monthly salary and distribution costs.

What I observe over and again is that people form S corporations before they have consistent cash flow. Then they skip payroll runs and instead grab payouts. The next thing they know, the entire year has passed without a single payroll run, raising the alarm with the IRS.

Before forming an S corporation, ask yourself: Do I have a stable cash flow to cover monthly payroll runs? If you said no, you might not be ready for a Scorp.

step 4: do your long-term business objectives include the involvement of investors or partners?

We’ve gone over the financial aspects of starting an S corp, and you may be thinking, “Yes! I’m ready.” But before you go all in, think about your long-term business objectives:

  •    Where do you envision your company in three to five years?
  • Do you intend to look for investors?
  • Do you expect to be acquired by another company?
  • Will you like to bring on a business partner?

These are crucial issues to consider before incorporating an S corporation.

S corporations cannot have more than 100 shareholders, and owners and investors must be US citizens or permanent residents. 

S corp revenues and losses are allocated based on stock holding. In other words, if you own 50% of the S corp, you immediately receive 50% of the profits.

This allocation occurs regardless of whether or not you have distributed dividends to your shareholders. If you have a silent partner, they will be taxed on business income based on the percentage of the company they hold. On the other hand, an LLC can allocate revenue and losses based on an operating agreement.

S corps can only have one type of stock. However, you can have both voting and nonvoting stock, which broadens the possibilities for bringing on new shareholders. 

However, it is more challenging to engage with investors than a conventional LLC, and you would need to retain a lawyer, which would increase your expenditures.

final words

Finally, a corporation or a partnership cannot own an S corporation. That means that if another company wants to buy your company, you’ll have to change your entity structure. This may also make finding investors for your company more challenging.

Before incorporating an S corporation, determine your long-term business objectives. An S company might not be the best choice if they include investors and partners.

If you believe you are ready for an S corp after answering these questions, seek a tax and legal adviser about your specific situation. Who can say? You may save thousands of dollars on your taxes in just a few months.

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