Is It Time to Elect S Corp Status? 6 Key Signs to Watch For

Thinking about electing S Corp status for your business? Discover the 6 key signs that it might be the right move for you! In this video, we’ll break down what S Corp status is, the benefits it offers, and how to know if your business is ready to make the switch. From saving on taxes to simplifying your structure, we cover everything small business owners need to know.

What You’ll Learn: 

• What is S Corp status?
• Tax advantages of S Corp election
• Signs your business could benefit from S Corp status
• Key steps to elect S Corp status
• Common mistakes to avoid

Whether you’re a small business owner, entrepreneur, or just exploring ways to optimize your business structure, this video is for you!

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This video is intended for education purposes and should not be taken as legal, financial or tax advice.  You should consult with a professional about your unique situation before acting on anything discussed in these videos.  Freedomtax Accounting and Multiservices Inc., Freedom Insurance Financial Inc., Freedom Realty Source Inc., and Freedom Immigration International Inc. are providing educational content to help small business owners and individuals become more aware of certain issues and topics, but it cannot give blanket advice to a broad audience.  Things are always changing, therefore, this channel may not contain the most up-to-date information.  Neither Freedomtax Accounting and Multiservices Inc., Freedom Insurance Financial Inc., Freedom Realty Source Inc., and Freedom Immigration International Inc. nor its members can be held liable for any use or misuse of this content.

TRANSCRIPTION

After much research, you learned that S-Corp is a popular strategy for a lot of businesses. Should you go ahead and make that election right after you open your business? Stick around to find out. I would imagine that if you are watching this video, you have some idea of what an S-Corp is.

However, for a mental refresher, an S-Corp or an S-Corporation is a type of tax designation under the U.S. Internal Revenue Code, and this allows businesses to pass corporate income, losses and deductions, and credits through to their shareholders for federal tax purposes. What this means is that the business itself, if it has a profit, is not going to pay the tax, but it flows through the owner and the owner pays tax based on their personal tax rates. By the way, I hear this all the time.

The S in S-Corp doesn’t stand for small business. It stands for subchapter S-Corporation. Just in case you’re ever in a tribute situation and you’re asked that question, now you know the answer.

It refers to subchapter S of the Internal Revenue Code. This subchapter governs the rules and regulations for this type of tax election. Subchapter S lays out how eligible businesses can elect to pass corporate income, losses, deductions and credits through to their shareholders to avoid the whole double taxation scenario, which is a key feature of the S-Corps.

Keep in mind that although the term S-Corp many people use it to describe businesses, it’s actually not a legal entity like an LLC or a corporation. Nobody can just open an S-Corp. Instead, it’s a tax classification or a treatment that certain businesses can apply for with the IRS.

Yes, you heard that right. You have to apply for this treatment or elect it by sending the proper forms to the IRS and they actually have to approve that election. You’re going to find out if they approved it because you’re going to get a letter of approval that is super important that you keep and send to your accountant.

Why is it so important? Well, sometimes the IRS makes mistakes and after they approve your business to be taxed as an S-Corp, when you go ahead and file electronically the 1120-S, which is the tax form that is filed for S-Corps, they reject it. So if you have proof that they did accept it and as of when that effective date is, then you can fight whatever penalties may arise from that rejection. Electing S-Corporation status can definitely save you money, but it has to be under the right circumstances.

Whether it’s the right choice depends on a number of different factors like your business income, the structure and your personal financial situation. I’m going to go over some signs that will allow you to understand if it’s better for you to elect S-Corp for your business or if it’s better to wait. The first question to consider is your business’s net income.

This is the first question I ask everybody that asks me. Your business should have at least $38,000 to $40,000 of net income. This is after expenses, okay? So if you don’t have at least that amount, the S-Corp election may end up costing you more than it saves you.

Sign number two is when you can pay yourself a reasonable salary. As the active officer in an S-Corp, you have to pay yourself a reasonable salary. It’s the law and this is based on the work that you perform for your business.

The IRS requires this because they want to make sure that people don’t elect S-Corp just to unjustly avoid payroll taxes, okay? And I know what you’re thinking. What is considered a reasonable salary? Well, it should reflect the market rates for similar work in your industry and region. Okay, so to put it in layman’s terms, basically, think of it this way.

If you were applying for a job doing the same work that you are doing for your business but for somebody else, what would you consider a fair wage to be? If the reasonable salary that you come up with leaves enough profit to justify the extra administrative costs of an S-Corp, then it could be a good choice. Sign number three, when your business has consistent or predictable income. S-Corps are generally better for businesses with stable or growing profits.

I talk to a lot of people that are just starting a business and this is the first time that they try this type of job or service that they’re trying to provide. So they have no idea how it’s going to go. My thought process is, why are you going to commit to a tax treatment from the start when you have no idea if the first year you’re going to have a loss? It may take you longer than you anticipated to start operating.

So why lock yourself into a tax treatment that requires you to have additional expenses for filing business tax returns, having payroll, if it’s not going to benefit you that year? Now, if you already know the business because that’s what you did before as a sole proprietor, then that’s different. I’ve talked to many people that already have done real estate, or they sell insurance, or they are barbers, or they do hair, right? And they already know what their cash flow is going to be. They already know their net income.

That way, there’s no surprises. So if you know you are netting well above $40,000 a year consistently, then it’s a no-brainer. In this case, electing the S-Corp treatment is definitely the right way to go.

Number four, when you’re in a high self-employment tax bracket. Why is that a no-brainer? Well, because these taxpayers already know how much they’re paying in income taxes and self-employment taxes. For sole proprietors and LLCs that are sole members, right? They’re taxed as sole proprietors in a Schedule C. All of your business profits are subject to not only your income tax, but your self-employment tax, which is 15.3%. S-Corps allow you to split your income into salary, which is subject to payroll taxes, and the distribution, which is the profit above and your salary.

That flows through a K-1, and it is exempt from 15.3% self-employment tax, which obviously is going to reduce the overall tax burden. Sign number five, when you can handle the additional administrative costs. S-Corps, like I said, require some extra steps, like filing payroll taxes, issuing W-2s for salaries and K-1s for distributions, and filing an actual corporate tax return, which is the 1120-S.

It also requires you to maintain stricter recordkeeping and compliance. So if you or your accountant can handle these responsibilities, the tax savings may outweigh the additional costs. Sign number six is when you don’t need to retain profits in the business.

S-Corps are pass-through entities, meaning the profits are passed to the owners or the shareholders and taxed at their individual tax rates. If you want to retain the profits in the business for growth, an S-Corp may not be the best fit compared to a Okay, so let’s go over an example so you can see side by side the difference between having income as a sole proprietor or a sole member LLC versus an S-Corp. So that, say your net income from your business is $150,000 after deductions, okay? As a sole member LLC or a sole proprietor, there’s no reasonable salary.

All of the income is taxed at 15.3% because it’s all your income, okay? So then on the other side for the S-Corp, we have $80,000 as your salary. The $80,000 is subject to income tax and payroll taxes, okay? So on the sole member LLC column or the sole proprietor, the entire $150,000 is subject to the 15.3% which is gonna make you pay $22,950 in taxes. On the S-Corp side, only the wages are subject to 15.3%. The $70,000 of distribution or the profit that remains is not subject to the 15.3%. So if you compare the difference, you’re gonna be saving $10,710 on the S-Corp side.

Not too shabby. So when is it not a good idea to elect S-Corp status? If your business isn’t generating significant profits or if paying yourself a reasonable salary would leave you too little to distribute as dividends, if you can’t comply with the administrative requirements or handle the payroll taxes or filings, if your state imposes high fees or taxes on S-Corps, for example, California has an $800 franchise tax plus a fee based on income. Then in these cases, maybe the S-Corp is not the best idea for you.

As always, I hope you found this information that I provided today helpful. Please reach out if you still have questions or if you already have decided you want to apply for S-Corp and you need help with the election. Please like and share this video to anyone that you know that has a business and has self-employed income.

Thanks for watching and we will see you on the next one. God bless you.

– End of Transcript

SUMMARIZATION

Understanding S Corp Status and Its Benefits

S Corp status offers businesses an advantageous tax classification under the U.S. Internal Revenue Code. Instead of double taxation, profits and losses pass through to shareholders, where they are taxed at individual rates. This structure is particularly beneficial for reducing self-employment taxes and enhancing profitability when the conditions are right.

However, not every business benefits from electing S Corp status immediately. Businesses must meet specific criteria to reap its full advantages. For example, having a consistent income of $40,000 or more after expenses is often the starting point. This ensures the tax savings offset the additional administrative costs.

Key Signs It’s Time to Elect S Corp Status

1. Consistent and Predictable Income: Businesses with stable profits exceeding $40,000 annually are better positioned to benefit from S Corp election.
2. Ability to Pay a Reasonable Salary: Owners of S Corps must pay themselves a reasonable salary, reflecting market rates for their industry. This balance ensures compliance with IRS regulations and maximizes tax benefits.
3. High Self-Employment Taxes: Sole proprietors and single-member LLCs pay 15.3% in self-employment taxes on their entire income. S Corp owners can reduce this burden by categorizing income as both salary and distributions.
4. Preparedness for Administrative Costs: Electing S Corp status involves payroll taxes, W-2 filings, and corporate tax returns. If you or your accountant can manage these responsibilities, the savings may outweigh the costs.

Potential Downsides and When to Wait

For startups or businesses with uncertain profitability, S Corp election may not make sense. Additional administrative expenses, state-imposed fees (like California’s $800 franchise tax), and the need for consistent cash flow can make this choice premature. It’s essential to evaluate these factors carefully before committing.

Real-World Example

Consider a sole proprietor earning $150,000 annually. Without S Corp status, the entire income is subject to 15.3% self-employment tax, totaling $22,950. With S Corp election, a reasonable salary of $80,000 would be taxed at 15.3%, while the remaining $70,000 distribution avoids this tax. The resulting savings would amount to $10,710, making S Corp status a clear advantage in this case.

S Corporations account for nearly 50% of all corporate entities in the U.S., highlighting their popularity as a tax-saving strategy.

Outbound Links:

1. IRS Information on S Corporation Election
2. Tax Foundation: Benefits of S Corps
3. Freedom Tax Accounting Services

Final Thoughts

Electing S Corp status can be a powerful tool for reducing taxes and increasing profitability, but only under the right circumstances. If you’re unsure, consulting with an expert, such as Freedom Tax Accounting, ensures your decision aligns with your financial goals. Contact us today to learn more about how we can help you make the best choice for your business.