When S Corporations Cost You

Somehow over time, S Corporations have attained an unwarranted holy grail status in taxation among laypeople and, honestly, even among some tax practitioners.¹ “You must have an S Corporation.” “I just started working for myself, so I need an S Corporation, right?” “My buddy has an S Corporation, so I got one, too.” I have heard it all. In my continued efforts to educate the American taxpayer on our needlessly complicated tax system and debunk tax myths, this article provides multiple, common examples of when it would be less desirable to do business as an S Corporation than another option such as a sole proprietorship/single member LLC (businesses with one owner) or a partnership (businesses with multiple owners).

Background

Under current tax law, S Corporation profits are not subject to self-employment taxes. Self-employment tax is the business owner’s equivalent of Social Security and Medicare taxes (a/k/a “FICA tax”). You’re likely familiar with these taxes being withheld from W-2 wages when you worked for someone else as an employee. For 2022, the Social Security tax is 6.2% of wages up to $147,000 and the Medicare tax is 1.45% of wages with no cap. Consider a salary of $100,000. Social Security and Medicare taxes combined on that salary will be $7,650. Not only does this amount get withheld and remitted from an employee’s paycheck, the employer matches this amount dollar for dollar and remits all to the federal government. In this example, a full $15,300 is sent to the IRS for this employee. Now consider instead that you as a business owner have self-employment income of $100,000. You are now responsible for these same taxes – now labeled self-employment tax – and you’re now also responsible for both sides of this tax. On $100,000 of self-employment income, you calculate a close amount in self-employment tax, $14,130² due to the IRS. Yikes! With this in mind, who wouldn’t want their business to be treated as an S Corporation? Aaaand that’s what we’re here to discuss.To be clear, I love S Corporations! They are a great strategy for some small business owners to legally reduce self-employment taxes. The problem is not S Corporations themselves, but that they are applied to many situations unnecessarily and once applied, it’s challenging, if not impractical, to undo them. A bandage is helpful when you cut your finger, but probably won’t help at all if you have a headache. Imagine pulling a super sticky bandage off your super painful head. It didn’t help and it hurts to remove, just like an unneeded S Corporation.

S Corporation Eligibility

Before we get into examples, I’ll point out that not just any business can operate as an S Corporation. So you need to not only consider if S Corporation status is optimal for your business, but if it’s even allowed. Among other rules, an S Corporation:

1. Must generally be a domestic US entity

2. May have no more than 100 owners (special rules for family members)

3. May typically not have nonresident alien owners

4. Is allowed only one class of stock

5. Has ownership limited to individuals, estates, certain trusts, and certain non-profit organizations

With all that said, let’s get into some examples.

Example 1 – No profit yet

You quit your W-2 job last year, took some time off, and started working for yourself this year. You’re the only owner of your new business, and you don’t have anyone working for you. You’re running around in a hundred different directions and drinking from a fire hose daily. Expenses are more than revenues this year, resulting in a loss. You expect this to be temporary, though, as more and more customers come in the door. You’re making many decisions about the financial side of your business, including tax options. After hearing from friends and colleagues that everyone has an S Corporation, you decide you probably should have one, too. After all, what could be the downside? Let’s first look at the cost of your business operating as an S Corporation. At the very least, your business will need its own annual tax return, Form 1120S. I have rarely seen a business owner attempt to prepare this type of tax return, but instead nearly all of them delegate its preparation to an experienced tax advisor who will charge for its preparation. Let’s say that fee starts in the $500-$2,000(3) range. Additionally, once someone is operating their business as an S Corporation, I also rarely see them continue to prepare their own personal tax return assuming they were doing so to begin with. So, potentially an extra expense here. Lastly, S Corporations are typically expected to report a payroll of some sort to their owners, so possibly a third expense and administrative hoop here. We’ll get into payroll in a subsequent example, but for now we’ll assume you don’t have one.Now, let’s look at the tax savings to operating as an S Corporation. In this example, you have a loss rather than a profit for the year. Reminder – S Corporations save federal self-employment taxes. Self-employment taxes are calculated on self-employment income. You don’t have any self-employment income this year. The tax benefit for you this year is…zero. Could there be other compelling reasons to elect S Corporation status in your initial year? Absolutely! But is there a self-employment tax savings to be had? No.

• S Corp cost - $500-$2,000 tax return preparation.

• S Corp benefit - $0 self-employment tax savings.

• Verdict: Maybe wait and elect S Corporation status in a future year if profit levels make sense. Maybe elect S Corporation status for the current year for some compelling reason not involving self-employment tax savings.

Example 2 – Low profits

Let’s assume the same situation as Example 1, except you do have a tax profit for the year to the tune of $30,000. For simplicity, we’ll also assume that the full $30,000 is subject to self-employment taxes and you have no other sources of self-employment income or loss for the year. Reporting this $30,000 as self-employment income would result in roughly $4,200 of self-employment taxes due. Alternatively, reporting this $30,000 of S Corporation income would result in $0 in self-employment taxes due. Aha! That’s a $4,200 savings, so it sounds like a win, right? Alas, no. Generally, S Corporation owners are considered employees of their own S Corporation. Accordingly, they are usually expected to receive a reasonable salary from their S Corporation.⁴ What constitutes reasonable is not entirely defined by tax law and outside the scope of this article. For our purposes here, know that the number is definitely NOT zero. Skirting S Corporation reasonable compensation may land you on the IRS’ no-no list and is not something I advise. And what do salaries have? Social Security and Medicare taxes – the employee’s equivalent of self-employment taxes. In short, S Corporations reduce self-employment taxes, but they don’t eliminate self-employment taxes. Now we have introduced two new costs into the S Corporation decision – Social Security and Medicare taxes, plus the costs of running payroll. Here we’ll make up some more numbers. Let’s assume a reasonable salary for you as an owner is $10,000⁵ for the year, so employer + employee FICA tax of about $1,500. We’ll assume the annual cost for a payroll service to issue your W-2 and remit required payroll tax filings is $500-$1,000⁶.On profits of $30,000, you’ll have Social Security and Medicare taxes on the $10,000 that ran through payroll, leaving $20,000 not subject to self-employment taxes because, again, S Corporation profits are not subject to self-employment tax. This saves you about $2,800 in self-employment taxes.

• S Corp cost - $500-$2,000 tax return preparation + $500-$1,000 payroll service + $1,500 FICA tax = $2,500-$4,500

• S Corp benefit - $2,800 self-employment tax savings.

• Verdict: If this is a one-off year and you expect profit to take off, maybe you’re comfortable electing S Corporation status now simply to get the paperwork out of the way. If, however, this will be a sustained level of profit, or you don’t know what to expect in terms of profit each year, an S Corporation status simply as a self-employment tax savings move may not work.⁷

Example 3 – High-paying W-2 job

You quit your W-2 job in June and started working for yourself in July. You’re the only owner and you don’t have anyone working for you. Because you retained a few clients from your old job, you already have steady revenue coming in and expect about $100,000 in profit from your business this year. Okay, now an S Corporation is a no-brainer, right? We previously calculated self-employment taxes on this amount to be about $14,000 and that’s a big number. Even after factoring in a reasonable salary and costs of preparing an S Corporation tax return and working with a payroll service, there will still be a high self-employment tax savings here, right? Well, let’s see.Let’s say that we set your S Corporation wages at $60,000. This gives you employer + employee FICA tax of $9,180. From our previous examples, let’s say it costs you another $3,000 in S Corporation tax return and payroll preparation fees. The total cost for the year for your S Corporation is $12,180. Compared to about $14,000 of self-employment taxes on $100,000 of profit, an $1,800 or so tax savings sound great, doesn’t it? To illustrate that taxes are complicated and nothing happens in a vacuum, we’ll add just one factor. Your former employer will report $200,000 of wages on your 2022 W-2 for services you performed from January - June. As it turns out, just this one factor will mean that rather than an $1,800 or so savings that you might otherwise expect, operating your new business as an S Corporation will instead waste several thousand dollars in unnecessary payroll taxes, not to mention administrative costs. Earlier we discussed that, after a certain earnings threshold, Social Security taxes are no longer withheld from employee pay. This means they are no longer matched by the employer, either. At your old job, you were paid well over the 2022 Social Security tax maximum wages of $147,000. This means the amount of Social Security you paid in for that job for 2022 stopped at $9,114 and so did your former employer’s matching amount. However, if you start receiving a new salary from a new employer, including your own S Corporation, the Social Security tax withholding and matching requirements reset. This means that your S Corporation will be required to withhold $60,000 * 6.2% of Social Security tax = $3,720, as well as match it and send the total (with Medicare taxes which aren’t capped) to the IRS. Perhaps you’ve had multiple jobs in one year before and have experienced this. If so, you may recall that your personal tax return contained a mechanism – an excess Social Security tax credit – that allowed for the Social Security taxes withheld at your second job to offset your personal income tax liability for the year. This mechanism makes sure that employees don’t pay more than the annual maximum of Social Security taxes, which is a good thing. Unfortunately, that same credit is not available to employers. So, while your 2022 personal tax return will show an excess Social Security tax credit of roughly $3,720, the $3,720 that your S Corporation matched is permanently gone. Had you instead reported your 2022 business profit on Schedule C as self-employment income, the self-employment tax calculation would have taken into account that you hit your annual Social Security maximum during the year and not calculated any additional Social Security taxes due. In a Schedule C scenario, you would not only have saved the cost of an S Corporation filing, but also the Social Security portion of an S Corporation salary. Note that you do still have a small amount of Medicare tax savings if operating as an S Corporation because there’s no cap on Medicare taxes. The math is: $100,000 S Corporation profit - $60,000 owner salary = $40,000 S Corporation income not subject to Medicare taxes at a rate of 2.9% = $1,160 of Medicare tax savings to operating as a S Corporation.

• S Corp cost - $500-$2,000 tax return preparation + $500-$1,000 payroll service + $9,100 FICA tax = $10,100-$12,100

• S Corp benefit - $1,160 self-employment (Medicare) tax savings.

• Verdict: An S Corporation is not looking good at all here. It would take a compelling reason other than self-employment tax savings to operate as an S Corporation in this transition year.

Those were just a few examples of when an S Corporation wouldn’t be an ideal tax structure. There are broader concerns, that include, but are not limited to:

1. Rental real estate

S Corporations reduce self-employment taxes. However, income from renting real property is typically not subject to self-employment taxes.⁸ When operating an S Corporation whose only activity is renting real estate, you are turning desirable non-self-employment income into less desirable self-employment income because of the owner salary requirement inherent in S Corporations. In other words, you’ve generated a self-employment (FICA) tax liability where one wouldn’t otherwise exist.

Whether your rental activity is reflected on your personal income tax return’s Schedule E or whether you’re filing a partnership tax return, either of these is generally going to be a better tax answer than an S Corporation.⁹  S Corporations are better suited to function as operating entities rather than for holding assets that typically generate passive income such as rental real estate.¹⁰

2. Increased administrative work

When comparing the tax differences between filing as a Schedule C v. an S Corporation, keep in mind the additional administrative inconveniences required to operate as an S Corporation:

• A cleaner set of books. Ideally, all businesses would have neat and tidy financial statements, but the truth is that accurate financial records are simply not the highest priority for most folks running a solo business and wearing numerous hats. An S Corporation tax return typically reflects the company’s Balance Sheet in addition to its Profit & Loss/Income Statement while only the latter is required for a Schedule C filing. Moving from a Schedule C to an S Corporation may mean transitioning from keeping up with your business activity in Excel to a true accounting platform and adding an outsourced bookkeeper to your team.

  1. An S Corporation will generally require that the owner claim an annual salary. This means regularly submitting accurate and timely filings of payroll taxes, ideally with the assistance of a payroll service provider. If you already have employees, then adding yourself to payroll likely isn’t a problem. If, however, you don’t have employees and don’t anticipate any, you may find establishing and maintaining payroll just for yourself is a nuisance. In either case, you’ll also need to make the determination of just how much salary is reasonable for you to claim – what is too low, what is too high, applicable tax law and court cases, etc.

  2. A one-time filing with the IRS is necessary to establish your business as an S Corporation. Depending on the state(s) in which your business operates, you may also encounter similar state-level filings.¹¹

3. States taxes

When deciding how best to structure your business for tax purposes, keep in mind state or similar jurisdictions where your company will have tax exposure a/k/a “nexus.” Although many state tax rules follow federal rules, some do not, and state tax laws change regularly in any event. For example, Tennessee subjects most corporations – including S Corporations – to its franchise & excise tax system but does not do so for sole proprietorships or general partnerships. An S Corporation may be subject to unfavorable state taxes that meaningfully diminish the federal tax savings.

4. Retirement plan contribution maximization

Looking to maximize your contributions to a retirement plan whose contributions are based on earnings such as a SEP IRA or a Solo401(k)? If so, your S Corporation salary will need to be high enough to support the level of desired contribution. If this salary level is significantly higher than what the IRS would consider reasonable, then the self-employment tax savings of the S Corporation diminishes as your salary increases.

5. Multi-owner flexibility

S Corporations are inflexible structures when it comes to how owners share profit, losses, and distributions. Business activity must typically be shared pro rata based on ownership percentages. Own 30% of the business and you’re generally required to receive 30% of the year’s cash distributions. Own 72% of the business and you’ll likely be reported 72% of the business’ loss for the year.

While manipulating owner salaries is one work around for this, there’s a self-employment (FICA) tax cost to doing so which undermines the value of operating as an S Corporation. If you’re looking for a tax structure that will allow owners to be allocated their share of business activity unrelated to their ownership percentages, you’ll need to consider a more flexible entity such as a partnership.

6. Qualified Small Business Stock/1202 Exclusion

You may have heard recently in the news about the “secret tax move” that the “ultra-wealthy” use to avoid capital gains taxes on the sale of their businesses. This is the Qualified Small Business Stock (QSBS) Exclusion under Internal Revenue Code Section 1202. It allows for the partial or fully tax-free sale of stock of up to $10M for specific businesses in specific industries assuming several requirements are met. One of these requirements is that the stock is that of a C Corporation; S Corporations won’t qualify.

This strategy isn’t really a secret. Rather, it has become more prominent lately due to tax law changes over time. IRS Code Sec 1202 was passed in the early 1990s as a way to incentivize technology startups. The law originally allowed an owner to exclude 50% of the gain from capital gains tax while the federal capital gains tax rate was 28%, resulting in a 14% savings. Okay, great, but you still had to operate as a C Corporation which meant the double taxation that’s inherent to C Corporations just to hope that your startup took off and that your initial, likely undesirable, tax structure was worth it when you sold.. Making this an even less interesting tax strategy, applicable federal capital gains rates continued to lower over time, but not for 1202 stock. For example, in 2003, the capital gains rate dropped to 15%, but the QSBS rules stayed the same. So, you could pay 15% on the sale of non-QSBS stock which compared to the 14% QSBS savings – 1% doesn’t seem like a huge savings for having to operate as a C Corporation out of the box. Additionally, the excluded gain factored into the Alternative Minimum Tax calculation, potentially making the tax savings even smaller. So again, yes, we have this gain exclusion, but it really doesn’t seem overly desirable. However, in the years since, tax law has changed several times, and we have a very different fact pattern. We’re now at a place where the QSBS gain exclusion is at 100% and C Corporations are at a flat 21% federal income tax rate.¹²

In short, the QSBS/1202 exclusion is now more desirable plus operating as a C Corporation now looks a bit more favorable. If your business could otherwise meet the Code Sec 1202 rules, operating as an S Corporation (or other structure) may not be an optimal move for you.

7. Qualified Business Income deduction

The Qualified Business Income (QBI) deduction was created by the Tax Cuts and Jobs Act of 2017. It’s a federal income tax deduction calculated very roughly as 20% of a pass-through business owner’s taxable profit from the business. The amount of deduction generated is based on factors such as income from the business, overall owner income level, business industry requirements, and W-2 wages generated by the business at higher levels of owner income.

When operating as a Schedule C, your entire business profit may be eligible for this deduction. For example, if your profit is $110,000, then your QBI deduction could be as high as 20% of that or $22,000. However, if you’re operating as an S Corporation and taking a reasonable salary of, say, $70,000, then your QBI deduction is reduced by this salary - $110,000 profit less your $70,000 salary = $40,000 profit included in the QBI deduction calculation * 20% = $8,000 maximum QBI deduction. A reduction of the QBI deduction will have a corresponding reduction in the overall tax savings to operating an S Corporation.

But also note that after a certain level of income, W-2 wages become necessary to generate the Qualified Business Income deduction due to how the law was written. So, while an S Corporation may work against you at lower levels of income with respect to the QBI deduction, it may actually be quite helpful for you at higher levels of income if you don’t have employees and could turn yourself into an employee via an S Corporation.

The QBI deduction is subject to numerous restrictions such that many otherwise eligible taxpayers may claim a reduced deduction or none at all. It should, however, factor into your analysis of whether an S Corporation is an optimal tax structure for your business.

Takeaway

As you can see, the ubiquitous S Corporation is often not an optimal strategy for numerous situations. And this is not an all-inclusive list, either. For example, changes in related tax law could provide an entirely different set of circumstances in which S Corporations are, and are not, beneficial. Everything here is not to say an S Corporation isn’t your business’ optimal tax treatment. Maybe it is! Rather, the point is that before choosing a tax strategy, discuss your choices with your tax advisor who will help you match your specific situation to applicable options.Considering if your business will operate most tax-efficiently as an S Corporation? Questions to ask:

1. Did this conclusion come from the result of discussions with, and advice from, a knowledgeable tax advisor who knows your tax situation and to whom you have paid a fee for such advice?

2. Have you – at least roughly – quantified the dollar savings of operating as an S Corporation net of the one-time and annual costs of establishing and maintaining an S Corporation?

3. Are there alternative tax structures that could be a fit for your business?

4. What might you be giving up to enjoy the self-employment tax savings of an S Corporation? Will you lose flexibility in future ownership? Will you have additional reporting and filing requirements that you’d rather not tackle now, or ever? Will you spend more money to maintain this structure than the tax savings might be? And so on.

In summary, S Corporations are sometimes a good fit for profitable, operating businesses whose owners are willing and able to understand and comply with tax rules for establishing and maintaining the S Corporation for the purpose of reducing, but not eliminating, self-employment taxes. They are not the tax panacea they are popularly portrayed to be.

¹This started before TikTok, so we can’t blame social media.

² The math here is 100% - 7.65% = 92.35% * self-employment income. This statutory reduction is to put taxpayers paying self-employed taxes on par with businesses receiving an income tax deduction for the 7.65% employer share of FICA taxes.

³ Yes, I know that’s a big range! But it gives us a place to start to avoid vague examples.

⁴ This is just the opposite from business owners who file a Schedule C (one owner) or as a partnership (multiple owners) who are not allowed to be employees of their own businesses. Taxes. Go figure.

⁵ This is an example for clarity. I am not saying that $10,000 is a reasonable salary on your $30,000 profit. I don’t even KNOW you!

⁶ Yes, these are reasonable amounts. No, you should not attempt to perform payroll functions yourself. This is not a place to cut corners. When you have an employee or two working for you, the cost of payroll services per employee will go down. Having just yourself on payroll, though, can be relatively expensive.

⁷ It’s fair to point out that there’s an income tax deduction for the employer side of FICA taxes paid on S Corporation owner wages, as well as correlating income tax deduction for ½ of self-employment taxes paid on self-employment income. Reducing the amount of FICA/self-employment taxes paid correspondingly reduces this income tax benefit. In a more robust analysis, this benefit loss would also be a factor.

⁸ For clarity, there are countless ways to make money in real estate and renting real property is only one way. Many real estate activities do generate self-employment taxes and S Corporations can often be valuable tax strategies for real estate activities apart from renting real property.

⁹ Rental real estate is sometimes held in a C Corporation. C Corporations pay tax on company income rather than the owner’s paying tax on company income. C Corporations in a rental real estate setting are typically reserved for non-profits minimizing Unrelated Business Income Tax exposure and for non-US investors wishing to legally avoid US taxation at the investor level.

¹⁰ It’s not just that holding rental real estate inside an S Corporation can convert non-self-employment income to self-employment income. There are other really good reasons to not place rental real estate inside an S Corporation such as a potential taxable event upon contribution of property to the company, a likely taxable event upon distribution of property from the company to you (even if you don’t sell it immediately), etc.

¹¹ The S Corporation election is made at the federal income tax level and is not reflective of the legal structure of your business. For example, corporations can be S Corporations and limited liability companies (LLCs) can also be S Corporations. If your business is an S Corporation, then your business is a corporation, LLC, etc. under applicable state law and also taxed as an S Corporation for federal income tax purposes. Whether your business will also be treated as an S Corporation for stateincome taxes will vary from state to state.

¹² https://www.qsbsexpert.com/history-of-qualified-small-business-stock-qsbs-section-1202/