What You Need to Know When Considering the S-Election

Often, I have clients come to me saying that someone told them they should have an S-Corp to save taxes or that their prior CPA set their brand-new business up as an S-Corp without analyzing the benefits against the costs.

What is an S-Corp? An S-Corp is a corporation or an LLC that has made a tax election to be treated as a corporation while electing to pass the income through to their shareholders. The business entity doesn’t pay federal income taxes, only the individual does. The shareholder will be paid a salary like any other W-2 employee that is subject to income and employment taxes, and the remaining net income is only subject to income tax. The shareholder can take additional distributions tax-free, within limitations.

There are several qualifications that must be met to qualify for the S-corporation status that are relatively easy to meet for most individuals. However, once the business meets the qualifications, there is still much to consider.

First, shareholders are required to be paid a reasonable salary. This salary must be reasonable to the work performed and not underestimated. Some factors that can be used to determine reasonable compensation are training and experience, duties and responsibilities, time and effort devoted to the business, what comparable businesses pay for similar services, and replacement cost. If the reasonable compensation for shareholders exceeds the net income of the business, there is no benefit to make the S-election. There would be no tax savings.

Secondly, by making the s-election, additional costs will be created such as bookkeeping and tax prep costs and payroll costs. If the reasonable compensation plus these additional costs exceeds the business net income, there is no benefit.

Lastly, once the reasonable compensation is determined, the tax savings can be calculated. The tax savings must exceed the additional costs to benefit.

If you are considering the S-election and have not discussed and calculated these items with your CPA, please do so before making any decisions. If you don’t have a CPA, please reach out. I would love to assist you.