ALL ABOUT S CORPORATIONS (S CORPS)

At some point, most of us are told about the magical S corporation. It’s like the unicorn of business entities. It’s unique and mysterious. Everyone thinks it’s super cool, but how do you really know? This section breaks down the intricacies of S corps, debunks some myths, and provides an actionable way to determine if S corps are worth looking into further. To start, we need to discuss some basics.

WHAT IS AN S CORP?

Repeat after me: An S corp is not a type of entity. Did you repeat it? Let’s try one more time. An S corp is not a type of entity. You may be thinking, The fuck, Braden? You just listed S corps under the different types of entities like a billion times in the last section.

And you’re right: I did, but I’ll explain. Entities are formed with the state. Remember that sole props and partnerships are our defaults, so they don’t require forms to file. Formal entities do. You file articles of incorporation with the state to form either an LLC or a corp (or one of those other less-common entities). 

After forming an LLC or a C corp, you make an election for your LLC or C corp to be taxed under special regulations provided by subchapter s of our tax code. Once you do that, you’re operating under what we call an S corp. I know. It’s quite bizarre. 

This is why we call an S corporation a tax status or designation rather than a type of entity. I almost always recommend forming an LLC and, when the time is right, electing for that LLC to be taxed as an S corp. This allows you to obtain an LLC sooner rather than later for the liability protection. When you’re ready, you can form an S corp.

I really dislike the name S corp because it really implies that you have a corporation, which is confusing. I’d prefer that we call them S LLCs when “S status” is elected on the LLC, but—alas—we must pick and choose our battles. Instead, I’m here to tell you why the name sucks as we continue to roll with it. 

For now, I want you to really cement the concept that when I or anyone else uses the phrase form an S corp, we really mean elect S corp tax status. I call your initial entity—the one you form before electing S corp status—your underlying entity. I already explained why I typically like LLCs as underlying entities. Due to issues of double taxation, you wouldn’t want to form a C corp as the underlying entity unless you’re ready to make the S election at the same time. I also find C corps a bit more difficult to form and manage. I’m not a fan.

SALARY VERSUS DISTRIBUTIONS

The first step to understanding S corps is to realize you will start to pay yourself differently. As a sole proprietor, you can really do whatever you like when you get paid by clients.

When you form an S corp, you’re effectively making yourself the sole shareholder and sole officer (employee) in your business. Think about it this way. You can own stock in a corporation and receive dividends as a shareholder. You could also be an employee of a corporation and receive a salary and paychecks from the business. You could also be an employee who owns stock in the company and who receives dividends and a salary. This last scenario is what happens in an S corp except that, if you are a solopreneur, you are the only shareholder and likely the only employee.

Once you form the S corp, you become an employee of the business and pay yourself a monthly salary in exchange for the services you perform for the business. You may then pay yourself a distribution as the sole shareholder.

Salary is your compensation for working in the business. Distributions are your reward for being the owner of the business.

Only the salary is subject to self-employment tax. Remember our super fun 15.3% self-employment tax? (I explain that in this blog post) This is how the S corp saves tax dollars. A sole proprietor pays this percentage on top of normal income taxes. In an S corp, the distribution portion is not subject to this tax.

Sounds awesome, right!? Real quick, let’s do a conceptual understanding check-in. Ask yourself what the trick is to saving taxes in an S corp. Assume you’re profiting $100,000 in your business. You decide to pay yourself salary payments every other week and profit distributions once per quarter. In order to save taxes, do you want higher salary payments or higher profit? Profit, right? Because you don’t pay self-employment taxes on the profit. But can you pay yourself a $0 salary? Nope.

Many new business owners get super excited when they learn how the S corp works and are ready to pay themselves a low salary to save taxes on the high distributions. Obviously, the IRS wants to prevent that, so the salary must be “reasonable.”

REASONABLE SALARY

Initially, the process of determining a salary for yourself seems super arbitrary. After all, if we’re the only one running our business, all the money we bring in is our own money. This is the part where we have to realize that our business is its own being. We perform work for our business, which needs to be compensated at a reasonable rate. Our business brings in its own money via things like reputation, good will, and the like.

Once you have determined that an S corp is the right way to go, you must determine what your salary will be. You can determine your “reasonable salary” by looking at the market rate of pay to someone providing your services, in your geographic area, with your level of expertise. Alternatively, consider how much you would have to pay someone else to do what you do. What would be a reasonable amount of pay to find someone qualified to fill your role?

The importance of this is that S corps are subject to fraud and abuse, so the IRS may look at the salary through a critical lens. Taking time to research and document your salary can help prevent some risk.

THE “MANY HATS” APPROACH

An alternative, and often better, approach for small business owners in determining reasonable salary is the “many hats” approach. As a solopreneur, you wear all the hats. Maybe you start your day as a secretary doing your own calendaring and email management. Then you put on your social media manager hat before you step into what you’d consider your core role. Think of your time spent in terms of a pie chart. Each slice is a different hat and is sized according to your time spent wearing that hat. The many hats approach allows us to consider time spent on these various tasks. I write about this more in the S Corp Bonus Guide in Unf*ck Your Biz.

How many slices are there? And what would a reasonable salary be for each of those different roles? This is what the many hats approach considers. You can balance and weigh your time spent in each area to come up with a reasonable salary based on your actual tasks rather than just what you’d earn as a tax attorney, interior designer, photographer, life coach, or whatever your industry is.

A CAUTIONARY TALE

When I first began assisting with business formations, S corps always made me a bit nervous. It almost felt like cheating—and you can so easily cheat by underestimating reasonable salary. It’s kind of like hiking up a mountain when there’s prize money waiting at the top for you. It’s a race, except you’ve gotta carry supplies up with you. So you grab a few things and rush to the top. The judge is there and says, “Well you won, but I don’t think you carried enough.”

Be wary of anyone who tells you that you can mountain climb without many supplies. In other words, be cautious of anyone who suggests you can make your salary super low. Some tax and legal pros are very conservative and will give you high estimations of reasonable salary. Others—and I have seen this often—say that $20,000 is fine for just about everyone. It’s not.

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I want to wrap up this section by telling you how reasonable salary makes sense to me. This will help you wrap your head around it a bit more. Generally, companies pay salary as compensation for services.

If you work for another company, they should pay you a salary based on your time and effort in addition to your geographical location, expertise, experience, and skill. Makes sense, right? You begin all your duties and receive your salary. Now, let’s say that you, along with all your coworkers, make some smart and strategic decisions in the company. The company sees record growth and decides to pay everyone a $10,000 stockholder distribution.

Did you work harder that year? Maybe you did; maybe you didn’t. Maybe you and all your coworkers are the embodiment of “work smarter, not harder.” Your salary is the compensation for your labor and expertise. The distribution is your reward for the company’s success.

Self-employment tax is only levied on the salary. Our tax code subjects only our earned income to Medicare and social security taxes. Earned income is income we have earned through our labor. Stockholder distributions are not earned income. They’re more like passive income or rewards.

S corps allow small business owners to treat themselves and their own companies the same way you were treated in that hypothetical. It only makes sense. If the fair market value of Simone’s labor and expertise is $70,000 when she works for Gymnastics Inc., it should be the same if she then starts her own business doing the same work. In both roles, compensation paid through dividends is a sign of company health and is taxed in the same manner, sans Medicare and social security contributions.

PAYROLL: WHAT IS IT AND WHEN DO YOU NEED IT?

As an officer of the S corp taking a salary, your business is now subject to the same rules as any other corporation with employees. You must not only pay taxes, but you must also have tax withholdings. Think about the last time you had an employer from which you got regular paychecks from a payroll company. They usually have all those perforated edges and look more legit than a handwritten check. Those checks have line items for federal and state taxes withheld from the amount paid to you. Once you have an S corp, you’re obligated to withhold taxes like those checks did.

You could handle these tax withholdings on your own, but the calculations for withholding are complex, and the penalties are a huge pain. Instead, pay a monthly fee for payroll services. The payroll service connects to your business bank account and withdraws funds to issue your paychecks. The checks take out the withholdings, and the payroll company sends the taxes where they need to go. You simply deposit that check into your personal bank account. In reality, you set up direct deposit. It’s all quite streamlined.

S CORPS AND BENEFITS

Running your medical insurance through the business can be a great strategy to reduce self-employment taxes even further. The insurance must be in the name of the business and paid by the business or, if in the name of the individual, the premium must still be paid or properly reimbursed by the business. Ideally, you have the business take care of the premium. This makes things much simpler.

The payments are then included on your W-2 as income. However, if classified correctly, the payments should not be subject to self-employment taxes, only income taxes. If you, as the owner of an S corp, determine that your reasonable salary needs to be $50,000, you’d run that through your payroll. You decide to have your S corp pay your health insurance premiums. Let’s say that’s $5,000 per year. That also goes on the W-2 as income, for income tax purposes. Your W-2 would show income $55,000, of which $5,000 would not be subject to income tax.

But this is not the best way to do it. With our example of $50,000 being a reasonable salary, you’d be better off paying a $45,000 salary plus the $5,000 premium. That nets you the $50,000 total as required and helps you save more in self-employment taxes. In short, that additional $5,000 you are no longer running as salary is taxed more like distribution, saving you (probably) 15.3%, or $765, in self-employment taxes while still meeting your reasonable salary threshold.

If done correctly, you can earn deductions that save you the income tax portion on your premiums as well. For more info, read my full blog post on medical expense deductions.

COST OF FORMING AN S CORP

In addition to reasonable salary” we should also look at the cost/benefit. You have already learned about the benefits. Let’s shift and take a look at the costs.

The primary expense is payroll. Some bookkeepers and accountants can run payroll. Many do not. I recommend using an established payroll company. This will typically cost you $40–$80 per month ($480–$960 annually).

In addition to payroll, you may choose to outsource your books once you form an S corp. Since S corps complicate things a tad, I recommend focusing on tightening up all your systems when you form one. If you don’t do a stellar job with your booking on your own, it’s time to outsource. A qualified bookkeeper will keep accurate books and records as well as create balance sheets. (I offer recommendations on how and who to hire in Chapter 12.) Costs range from $100 to $500 a month ($1,200–$6,000 annually). 

One way you can analyze these expenses is through a cost benefit analysis. How much will the cost to form the S corp, annual payroll, and bookkeeping cost you? Do you still save taxes when you contrast that with the anticipated savings you’d get from the S corp? This is our default analysis.

However, I encourage you to think about this another way: Hiring a bookkeeper and getting on payroll will streamline your business. You’ll have taxes on autopilot. You’ll also have access to completed financial reports for your business on a monthly basis. This will not only free up your time, but it’ll also give you a greater sense of confidence in your business and help you step further into the CEO role by giving you better numbers to consider.

With that in mind, consider the breakeven point—the point at which the savings of the S corp will be equal to the additional costs. With the benefits I just noted, this is the ideal time to form an S corp.

HOW TO KNOW IF YOU’RE READY FOR AN S CORP

This is the big-ticket question. People tend to toss around a magic number with regard to what your income should be when it’s time to form an S corp. I often hear $100,000. Other professionals say $60,000. However, the number really depends on your business and industry.

If a reasonable salary for you would be $40,000 and your business is netting $60,000, you might be a great candidate. In other industries, $40,000 might not be reasonable, so the right time may not be until you hit six figures.

I have my own shortcut to help business owners like you determine if and when they’re ready to form an S corp. The key is determining your net business income after reasonable salary, or, remember, we also call this business profit when you have an S Corp. 

Let’s break down net business income after reasonable salary. First, pause for a minute and work out in your head, based on what you’ve learned so far, what this could be. Do you have it? 

First, consider net business income. We know what that is: the profit. Net business income is gross business income less cost of goods and less deductible business expenses. From there, there’s just one more step: deduct from that the reasonable salary. This is where we can have a large range in our estimated S corp savings. One tax pro may give you a reasonable salary that is $30,000 less than another. Ultimately, as the business owner, it’s your call to determine reasonable salary. Once you have that, deduct it from your net income to get net income after reasonable salary. 

Assume your gross business income is $100,000. You have deductible business expenses of $20,000. Your net business income is $80,000. After some research, you determine that your reasonable salary should be $60,000. Therefore, your net income after reasonable salary is $20,000. This final amount is the total on which you save self-employment tax. Thus, if you calculate the self-employment tax you would have paid on that chunk of money, that is how much you’d be saving with an S corp.

Remember: If income is less than $137,000, self-employment tax is 15.3%. In our example, we can calculate 15.3% of $20,000, which is $3,060. This is a rough approximation of how much you’d save with an S corp if those were your numbers. You’d want to compare that savings to any additional costs to find true savings.

Note there are additional tax considerations that complicate this math. This is a good starting point.