Well...it depends!
Hardly a satisfying answer, I know… But there are good reasons why electing S-Corp goes beyond how much self-employment tax you’re saving.
The allure of S-Corp status as a tax planning strategy is undeniable. It's a hot topic among financial experts and influencers. But is it really the silver bullet for tax savings, or are there hidden complexities you should be aware of?
Introduction
S-Corp can indeed be a powerful tool for tax savings. However, many business owners dive into it without fully understanding its advantages and limitations. The reality can be a shock: limitations on retirement savings, additional workload, and unexpected fees, not to mention the challenge of reversing the decision once it's made.
This blog aims to demystify what S-Corp is, exploring its pros and cons, and its financial planning implications. This way, you can make a decision that you’re confident about.
What is an S-Corp
First off, S-Corp is a tax designation rather than a business entity. It's common to wonder whether to choose an S-Corp or LLC, but here's a twist: you can have an LLC that opts for S-Corp tax status.
LLC vs S-Corp Taxation: Key Differences
Before we talk about the benefits vs drawbacks, it’s important to understand how S-Corp impacts your tax situation.
In an LLC, your business earnings are subject to self-employment tax (15.3%), which appears in Schedule C on your tax return.
In an S-Corps, you, as the owner, have 2 streams of income:
A newly added W-2 and the net income from the business.
The net income (after taking out your new salary from W-2 and half of FICA) appears in Schedule E of your tax return, aka not subject to self-employment tax.
The biggest advantage of S-Corp is savings on self-employment tax. For a business that nets over $200,000 a year, you can potentially save up to $18,000 in self-employment tax. *
Pros and Cons of S-Corp
Now, you might be tempted to hit the x on the top right, but please bear with me here. There are typically no free lunches, and S-Corp is no different. Could it be amazing for you? Absolutely! But there are definitely situations where you don’t want to S-Corps.
Let’s go more in detail into the advantages and drawbacks of S-Corps:
Pros
Reduced self-employment tax
Additional Perk: Easier tax withholding from paychecks, aiding in Safe Harbor compliance
Impact on QBI Deduction
Cons
Cost: Just like anything else, S-Corp isn’t free
Upkeep: More administrative work
Social Security Impact: Potential reduction in future benefits.
Retirement Contribution: Possible limitations.
Impact on QBI Deduction
Shareholder limitation : resident status and numbers
We have covered pros pretty extensively in the previous section so let’s focus more on the cons here:
1.Cost:
Besides the fees for S-Corp application or possibly an annual fee to maintain S-Corp status, there are several other things that you’ll need to pay for:
Tax Filing Fees: Expect to pay for a separate S-Corp tax return, with the national average cost around $900.**
Payroll Service Fees: Setting up a payroll system for your W-2 can cost approximately $600 annually.***
2.Upkeep:
In addition to the extra fee you’re paying for S Corp, you’ll also need to handle the added work of record keeping for S-Corp and payroll. Unless you have outsourced help, that will eat into your already busy days.
3.Social Security Impact:
A less known consideration is that electing S-Corp status might lower your social security in the future. This is the main tradeoff between paying less self-employment tax vs getting less social security.
When you avoid self-employment tax on the net income in S-Corp, the government would also say, “Well, this is not your ‘Earning’ then”. Since Social Security is calculated based on your earning history, you could be making less in the government’s eyes, therefore, entitled to less social security when you retire.
4.Potentially Lowering Your Retirement Contribution:
Besides the very important Reasonable Wage criteria, salary also impacts your retirement savings (and potentially QBI deduction) when you elect S-Corp.
One one hand, lower salary means more self-employment tax savings; on the other hand, you might be shooting yourself in the foot by lowering how much you can contribute to your retirement accounts.
Don’t forget that retirement contribution is generally tax-advantaged as well, so you could be saving on self-employment tax but losing out savings on income taxes by limiting retirement contribution.
I have two examples on this point. Let's compare an LLC with $250,000 of annual net income vs the same business with an S-Corp selection, with $75,000 W-2 wage for the owner.
Solo 401(k)
For solo entrepreneurs, a Solo 401(k) allows contributions up to $69,000 in 2024, split between $23,000 employee deferral and $46,000 employer profit sharing.
As an S-Corp, your profit sharing is limited to 25% of your salary. For example, with a $75,000 salary, your total contribution drops from $69,000 to $41,750, potentially missing out on $27,250.
SEP IRA
SEP IRAs typically permit contributions up to the lesser of $69,000 or about 20% of net earnings for self-employed individuals.
Under an S-Corp with a $75,000 salary, your contribution limit is reduced to around $18,750; reduced from $47,250 from the LLC. A significant difference.
Here’s a summary chart to compare figures:
Max Retirement Contribution with Example above (2024)
Solo 401(k) | SEP IRA | |
LLC | $23,000 EE + $46,000 ER | $47,240 |
S-Corp | $23,000 EE + $18,750 ER | $18,750 |
5.QBI Deduction Changes
If you read the pros and cons list closely, you probably saw that QBI deduction change was listed under both Pro and Cons. This is where the complexity lies. S-Corp can be either good or bad for you depending on the type of business as well as your business income.
You can read more here on What is QBI deduction? In a nutshell, it gives self-employed people a tax deduction. It was introduced in 2018 as part of the TCJA tax act and sunset in 2026.
QBI deduction calculation is fairly complicated so I’ll focus on the most relevant factors here:
Under Phase Out: S-Corp potentially lowering QBI Deduction
Generally, you can deduct lesser of 20% of QBI or 20% of your personal tax income. If you have S-Corp, your QBI will be lower since now your salary and half of FICA is a part of business expenses.
Over Phase Out/Non-SSTB: S-Corp potentially lowering QBI Deduction
If your business income is above phase out and your business is not a Specified Service Business (SSTB), potentially, your QBI deduction will change to be abased on W-2 wages. If you don't have employees, your LLC essentially has no W-2 wages, which means your QBI will be 0. However, electing S-Corp means that your business would have wages, allowing you to take QBI deduction. It's also counterintuitive to the common sense of lowering your salary to save more on self-employment tax. It's possible that you want to set a high salary to max out your QBI deduction in this case.
This is a fairly complex calculation so do rely on your tax pro to run scenarios and don’t attempt to do this yourself. Please feel free to reach out to me or your trusted financial planner on how QBI can affect your taxes in different scenarios as well.
6.Shareholder limitation (Resident status/Numbers)
If you’re not a permanent resident or a citizen but you have started a successful business in the U.S., unfortunately, S-Corp would not be available to you. This limitation also applies to other shareholders in the company. You’re also limited to 100 shareholders in an S-Corp.
Admittedly, these points don’t apply to everyone but it could be very important to remember if it fits your situation.
Conclusion
S-Corp can absolutely be a wonderful way to save taxes, should you understand all the implications. At the end of the day, you know your life the most so isn’t it good to go into a big decision knowing that you’re going to be happy with it? A slightly self-serving but honest point to close out - If you still struggle with the decision, it might be time to reach out to a financial planner who specializes in business owners so you can move forward with confidence.
*Tax saving assumptions: assuming you earn a W2 wage of $60,000 after electing S-Corp status. Costs associated with electing S-Corp is $5,000.
** Likely higher now. Number based on NAS white study. https://accountants.intuit.com/taxprocenter/practice-management/how-do-your-tax-preparation-fees-stack-up
***Number based on this article: https://www.thesmbguide.com/payroll-services. Added slightly more based on the popular payroll services and realistic information
Disclosure:
All written content on this site is for informational purposes only.Opinions expresses herein are solely those of Savor Financial, a Core Planning brand.All information and ideas should be discussed in detail with your individual advisor prior to implementation. Investment advisory services are offered through Core Planning, LLC.The presence of this website on the internet shall in no direct or indirect way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services.The information contained here is general in nature and is not intended as legal, tax, or investment advice. Further, the information contained herein may not be applicable to, or suitable for, the individuals’ specific circumstances or needs and may require consideration of other matters.CP does not provide legal advice or drafting services. Estate planning is considered incidental within the context of a financial plan. We will coordinate with your family attorney of choice. CP is not a certified public accountant and does not provide tax filing services. Tax related advising is considered incidental within the context of a financial plan. We will coordinate with your CPA of choice.
Comments