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Is the S Corporation the Right Entity Type for Your Business?

by
Sonu Shukla
on
12/18/2019
Is the S Corporation the Right Entity Type for Your Business?

The S corporation (or “S corp”) refers to Subchapter S in the Internal Revenue Code, and it has become a favorite entity type for small business owners and accounting professionals alike. This has been the case since 1997, with about 62 percent of all U.S. corporations filing as an S corp since 2003. 

One reason why S corporations are so popular is because they don’t have to pay income taxes at the entity level, like their C corporation counterparts. Just like sole proprietorships and partnerships, S corps are pass-through entities, which means that the business profits are taxed at the owners’ individual levels (passed through to them).

With the passage of the Tax Cuts and Jobs Act, the legislation included a generous new benefit called the qualified business income (QBI) deduction for pass-through entities. Taxpayers with total taxable incomes in 2020 under $213,300 ($426,600 for married couples filing jointly), up from $210,700 and $421,400 in 2019, stand to save a great deal on taxes if they are self-employed or own a small business.

However, the tax reform also permanently slashed corporate income tax rates to 21 percent, which is often much lower than the personal income tax rates for higher-income taxpayers. When deciding how to structure a new business, or restructure an existing one, it begs the question of whether or not S corporations are as beneficial to business taxpayers as they’re made out to be.

Let’s discuss the pros and cons of using an S corporation and whether or not it’s the right entity for your business.

Pro: S corps don’t result in self-employment tax.

One of the chief draws of forming an S corp, especially for solo business owners, is that you don’t have to pay self-employment tax on the profit posted as you do with a sole proprietorship on Schedule C, or as a partnership or LLC taxed as one.

Self-employment tax adds up quickly and can often result in snowballing tax bills among freelancers and small business owners who haven’t carefully earmarked enough of their earnings for estimated taxes. Not owing it at all is a major advantage of using this entity type.

Con: Reasonable compensation rules come into play.

While self-employment tax is not owed on S corp profits, you are required to pay yourself a salary under the reasonable compensation laws. “Reasonable compensation” means that you must pay yourself according to what area and industry norms would dictate someone performing comparable services gets paid. It also means having to buy workers’ compensation insurance and cover all payroll taxes and mandatory contributions, such as state disability and family leave programs, and report your earnings on a W-2 form as though you have a job.

While the IRS looks at facts and circumstances, such as if the business is new and bringing in little or no money, reasonable compensation rules have been more strictly enforced in recent years. While an engineer could earn $100,000 a year in their area, but their new business brings in $30,000 that year, it’s reasonable that they wouldn’t pay themselves a salary, or a tiny one. However, reasonable compensation compliance can end up costing more than self-employment tax in some cases.

Pro: S corps don’t have to pay corporate income taxes.

Another major draw of an S corp is that it doesn’t have to pay entity-level taxes at the federal level. The profit is passed through to your individual tax return. However, as corporate tax rates have been permanently reduced after the tax reform, it may require additional calculations and projections to determine which entity offers a better deal.

Con: Some states and cities might not recognize S status.

Some states have their own corporate income taxes and additional requirements to impose on residents or business owners operating within that state. In New York, for instance, S status is recognized at the state level but not at the city level. New York City residents and business owners must pay the city corporate income taxes as though they are C corporations. While these local business taxes are, at least, deductible on the federal level, they can be quite steep.

Con: S corps carry a higher administrative burden than simple Schedule C filings.

Having an S corp can save a great deal of money, but it also requires far more technical accounting knowledge. A spreadsheet with your income and expenses may be fine when you’re filing a simple self-employment return, but you need to keep a formal set of books and submit documents like balance sheets in order to get your S corp taxes correctly prepared. This means more expensive and frequent accounting services plus legal compliance.

Con: Ownership is restricted to U.S. citizens only, and it can be difficult to change ownership.

As more entrepreneurs find customers and business partners around the world today, having a foreign business partner means that S corps are not an option. A company you wish to keep private and small may be fine with S status, but C corporations are more liberal with respect to what kinds of people and entities can own shares, and they could be better if your company is seeking funding for rapid growth.

There are upsides and downsides to any business entity, and S corporations are no exception. Working with a tax professional can be very helpful when choosing your business structure, as they can help you with proactive tax planning to minimize your future liabilities to the IRS.

Sonu Shukla, CPA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].

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Sonu Shukla

Sonu Shukla

Sonu Shukla is a CPA, accountant, and tax preparer based in Orlando, FL. Sonu Shukla can assist you with your tax preparation and planning needs. Sonu is more than just another accountant in Orlando, Florida; he is a small business owner himself. It is a position in life that grants him the perspective and insight to emphasize with his clients, bringing them the best service possible. A Certified Public Accountant and a Certified Financial Planner, Sonu possesses the skills, education and experience to demonstrate unerring business acumen and passionately planned financial strategies. Being proactive is key for Sonu, tailoring highly efficient tax plans for his small business clients, all in a one on one environment where he and the client can bounce ideas around until every detail is worked out.

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