The Disadvantages (and Advantages) of an S-Corp
There are a million and two resources on why you should file as an S corporation, but few on if you’re actually ready – and if it’ll really save you money when it’s time to file your taxes.
As a sole proprietor or LLC, you’re responsible for income taxes based on your tax bracket and the additional 15.3% Self-Employment tax which covers Social Security (12.4%) and Medicare (2.9%).
As an S-corp, you only pay income tax on anything beyond your W-2 salary – not the additional social security and medicare taxes.
AKA, the promised “tax savings.”
But while there are advantages of filing as an S-corp, there can also be disadvantages. Most of which depend on whether your business is in the right place to file as an S-corp or if it’s better off staying (or filing as) a sole proprietor.
The Advantages of an S-Corp: Your Tax Savings
The biggest advantage of an S-corp is the tax savings – namely, the 15.3% self-employment tax.
Anything beyond your “reasonable compensation” is only taxed via income tax (the tax on your overall income, a percentage that varies based on your overall annual income), not self-employment taxes. And anything extra paid to you is done through shareholder distributions– the income from your business’s net profits, what remains after paying all expenses.
Which is also why so many companies (like Collective, Bench, and Lettuce) recommend business owners file as an S-corp. You can keep your LLC and elect to be taxed as an S-corp – allowing for your business entity to exist as-is, but getting the benefits of an S-corporation.
The Disadvantages of Filing as an S-Corporation
When something sounds too good to be true, it usually is. If all of that sounds amazing and you’re wondering why more businesses don’t file as an S-corp, it’s because of the rules and regulations that go right along with it.
Let’s talk the disadvantages of filing as an S-corp:
You’re Responsible for Determining Your Reasonable Compensation — And Justifying it to the IRS
Your reasonable compensation is based on what would ordinarily be paid for similar services by a similar business under similar circumstances – calculated by you and then justified to the IRS, because it’s up to them to approve it.
And if you’re not paid a reasonable compensation (based on the final decision of the IRS), your dividends may be reclassified as wages, leading to additional taxes and penalties.
Unfortunately, there is no set wage for reasonable compensation, it’s determined on a case-by-case basis – although your CPA can help with this!
If You Have to Revoke Your S-Corp Election, There’s a Five-Year Waiting Period
One of the biggest considerations before filing as an S-corp is the consistency of your income. If for some reason you can’t consistently pay yourself a salary – or the cost of maintaining an S-corp becomes too expensive for the savings – you can (or will need to) revoke your S-corp election.
Doing so, however, will put you on a five-year wait period before you can file as an S-corp again.
Increased Administrative, Payroll, and Legal Fees
This all depends on where you’re located – but when you file as an S-corp, you’re facing more accounting fees (to change your structure $500+), administrative fees (payroll processing $550+), and financial fees (bookkeeping $500+ monthly, tax preparation $1,500+ annually).
Depending on your “reasonable compensation” your fees may outweigh the tax benefits. You’ll also need to register for unemployment and state withholding taxes.
You’re Following New Rules
There’s a good reason I recommend that every S-corp have a bookkeeper: the new rules.
S-corps have different rules than LLCs, including rules for paying yourself, reimbursement, and writing off things like your home office.
When is The Right Time to File as an S-Corporation?
Like everything else when you’re running a business – there are advantages and disadvantages to filing as an S-corporation to potentially save during tax time. And whether it’s right for you – and for right now – depends on your individual circumstances.
Want to know if an S-corp is worth it for you? Download our quick resource with the 5 questions to ask your CPA before becoming an S-corp and a fill-in-the blank style worksheet so you can do the math and understand if an S-corp is right for you! → Download your resource here!
