An S corporation (S-corp) is a federal tax designation that Congress created so small businesses could receive favorable tax advantages. An LLC (limited liability company) or corporation can elect S corporation status with the IRS, but there are requirements. To become an S-corp, you must set up payroll, have less than 100 shareholders, and only issue one class of stock.
How an S Corporation Works
An owner cannot register their business as an S corporation. They must first register the business as either an LLC or a corporation in the state it’s primarily doing business in. Once registered, they must submit IRS Form 2553 to the IRS to indicate that they’d like the company to be an S corporation—this process is called “electing S-corp status.”
The main reason a business owner would want to elect their LLC or corporation as an S-corp is to save money on taxes. An LLC avoids paying self-employment taxes with a dividend payout. A corporation avoids the 21% tax at the corporate level.
The main downside of an S corporation is the additional maintenance. Someone with a simple LLC will have to set up payroll and pay payroll taxes to be able to file taxes as an S-corp. There’s also a possibility that you will save little to no money on taxes—which we’ll discuss below.
How to Save Money on Taxes With an S-Corp
As an LLC, you’ll pay less in self-employment taxes. Typically, as a business owner, you’ll pay 15.3% of net profit for Social Security and Medicare taxes.
For example, if your business earns $80,000 in net income, you will owe $12,240 ($80K x 15.3%) in self-employment taxes.
If you elect S-corp status, you only pay self-employment taxes on a “reasonable” salary for the job you do as an owner. I understand it may be challenging to estimate a “reasonable” salary as a business owner, but that’s how the IRS frames it. So, imagine you’re paying someone to do your job, how much would you pay them?
For our example, let’s say a reasonable salary for your work is $50,000 a year. The self-employment tax on $50,000 is $7,650 ($50K x 15.3%).
What about the self-employment taxes on the other $30,000 in net profit? There are none. You pay no self-employment taxes on that profit, because it’s paid out as a dividend—which saves $4,590 in taxes!
As a corporation, if you elect S-corp tax status (instead of a C-corp), then you avoid the 21% corporation tax on profits.
The tax savings for both LLCs and corporations can be massive.
Who an S-Corp Is Not Right For?
If the S-corp tax advantages are so beneficial, why would anyone choose to be taxed as an LLC or a C corporation?
As an LLC, if you don’t earn more in net profit than what a reasonable salary would be, then you won’t save more money in taxes. While you technically can elect S-corp status, the extra paperwork would yield no tax savings.
In addition, there are factors that force corporations to be taxed as a C-corp vs an S-corp. These include having over 100 shareholders, issuing more than one class of stock, and having foreign owners.
Who an S Corporation Is Right For
Generally speaking, smaller businesses earning net income in addition to the owner’s pay may benefit from electing the S-corp tax designation. Here are a few scenarios where the tax status could be advantageous:
- Freelancer: A freelancer such as a graphic designer or digital marketer earning more than their typical market rate
- Consultant: A consultant earning income as a percent of the project cost or by a percent of revenue increase
- Retail business owner: A store owner, such as a hair salon or boutique, that is earning more profit than a reasonable salary as a store manager
- Seasoned professional-based business: A doctor, attorney, or accountant firm earning more than a typical hourly rate for their profession
- Corporations with under 100 shareholders: A corporation with under 100 shareholders may be able to avoid the 21% corporate tax rate
Pros & Cons of the S-Corp
- Save money on payroll taxes: As you saw in the example above, an LLC business with high net profit can save thousands of dollars in taxes.
- Avoid double taxation: When you elect S corporation status for a corporation, you avoid the 21% corporate tax rate.
- Less reporting: Compared to a corporation, an S-corp requires less tax reporting—annually, instead of quarterly.
- Payroll set up: If you aren’t already taking out self-employment taxes from a salary, you’ll need to set that up.
- Additional yearly documents: Every year, the S-corp must fill out Form 1120s (tax return for S-corp) and send its shareholders a Schedule K-1 form.
- Possibly more IRS scrutiny: The IRS may check to see how “reasonable” your salary is. If they deem it lower than the market rate, you may owe more in taxes.
- May turn off investors: Because of the 100 shareholder limit, some investors may be turned off by the business structure limitations.
S Corporation Costs
Costs to create an S corporation vary depending on if you choose to do-it-yourself, use an online legal service, or hire an attorney. Before discussing costs, you need to understand the different terminology around S-corps.
While you technically can’t register your business as an S-corp, some online legal services will infer that they can. This marketing language is for simplicity. In reality, they’re likely registering your business as a corporation and electing S corporation tax status.
If you’d like to form an LLC—for the benefit of less yearly paperwork—you will likely need to register the LLC first, either by handling it yourself or using an online legal service. Once registered, you or the service can file the paperwork to elect S-corp tax status.
Here are general costs associated with designating your business as an S corporation:
- IncFile initial business registration: Free (plus state fees). If you have never registered your business as a legal entity with the state, IncFile will do it at no-cost with a complimentary S-corp election. Typically, online legal services charge around $150 for a business and S-corp registration.
- File IRS form yourself: Free. Submitting IRS Form 2553 to elect S-corp status for an LLC or corporation is no-cost when you do it yourself.
- Pay online service to elect LLC S-corp status: Around $50. If you’d like to use an online legal service, such as IncFile, to elect S-corp status, there is a small fee to submit IRS Form 2553 on your behalf.
- Attorney: Around $500. An attorney can cost a lot more than an online legal service, especially if they are drafting operating agreements or articles of incorporation for a complicated corporation.
- Franchise tax: $800 to $6,000. In California, all LLC and corporations must pay a franchise tax on profit. This tax varies depending on business entity type and net profit.
Online legal services assist with various legal tasks, particularly those starting a new business, including business formation. If you’re considering using a legal service to create the S-corp, here are a few popular companies to consider:
Currently, IncFile has the best deal for registering a business legal entity (LLC or corporation) and S-corp—free, plus any state fees. Typically, it will cost around $100 to register a business with an online legal service.
2. Rocket Lawyer
Rocket Lawyer is an affordable option if you need ongoing legal advice or need to customize legal documents. For $39.99 per month, you receive a free business and S-corp registration. With the plan, you also receive unlimited custom legal forms and legal questions answered by an attorney.
Compared to Rocket Lawyer, LegalZoom provides a few additional legal services, such as intellectual property submission. It also offers different pricing structures for legal advice and legal docs. You may want to consider registering your S-corp with LegalZoom if it better fits your particular legal needs.
Alternatives to the S Corporation
You may be wondering what the difference is between an S-corp, LLC, and C-corp and how to choose between them for tax purposes? Each structure has its pros and cons. And in some circumstances, you must be a C corporation—such as when there is a foreign shareholder.
You will want to stay as an LLC—and not elect S-corp status—if your business won’t earn more net profit than a reasonable salary for your position. Staying a simple LLC will save you time by requiring less documentation than an S corporation.
A corporation that doesn’t elect to be an S-corp is designated a C corporation (C-corp). Most companies would rather not be a C-corp because they have to pay a 21% corporate tax. However, in certain situations, the business must be a C-corp such as having over 100 shareholders, a foreign shareholder, or when trying to attract venture capital.
Typically, you will only want to be a sole proprietor if you have a business that is at a low risk of being sued by a customer or vendor. Many low-risk businesses save money by skipping the legal step to register a business as a legal entity. However, registering your business as an LLC or corporation would protect your personal assets if a lawsuit were ever filed against the company.
For most business owners, the choice to become an S corporation is straightforward. If you’re earning more net income than a “reasonable” salary for your position, you could save money in taxes by electing S-corp status. If you’re creating a complicated business structure with multiple shareholders, consider working with a local business attorney to assist with your situation.