Handbook / Business structure

S corp election for a small business: how it works and when to consider it

The S corporation election is the tax move most often suggested to growing freelancers and small business owners. It can lower taxes, but it also changes how you pay yourself and adds ongoing work. This guide explains the mechanics so you can have an informed conversation with a tax professional.

What the election does

An S corporation is not a type of company you form; it is a tax status. A corporation or an eligible LLC elects it by filing Form 2553. The business then generally does not pay federal income tax itself. It files Form 1120-S and passes income, deductions and credits to shareholders on Schedule K-1, who report them on their own returns.

Why people consider it

As a sole proprietor or single-member LLC taxed by default, your entire net profit is subject to self-employment tax. As an S corporation shareholder who works in the business, you are an employee. You pay yourself wages, which carry Social Security and Medicare taxes through payroll, and you can take remaining profit as distributions, which are not subject to those payroll taxes.

That split is where the potential saving comes from. It is also where the IRS focuses.

Reasonable compensation

The IRS says S corporations must pay reasonable compensation to shareholder-employees for services provided before non-wage distributions are made, and it can reclassify distributions as wages when salary is too low. Factors it lists include:

• training and experience
• duties and responsibilities
• time and effort devoted to the business
• dividend history
• payments to non-shareholder employees
• timing and manner of paying bonuses
• what comparable businesses pay for similar services
• compensation agreements
• use of a formula to determine pay

If most of your profit comes from your own work, a reasonable salary may absorb much of it, which reduces the benefit. Document how you set your salary.

Eligibility

According to the IRS, to be an S corporation the business must, among other requirements:

• be a domestic corporation or eligible entity
• have no more than 100 shareholders
• have only allowable shareholders, which excludes partnerships, corporations and nonresident alien shareholders
• have only one class of stock

Timing the election

The Form 2553 instructions say to file it no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the preceding tax year. File too late and the election may apply only from the following year, although the instructions describe relief for late elections in some cases.

The extra work and cost

An S corporation adds:

• Payroll for your salary, with withholding and employment tax returns such as Form 941 quarterly and Form 940 annually.
• A separate return, Form 1120-S, plus Schedule K-1.
• State requirements, which vary; some states tax S corporations or do not recognise the election in the same way.
• Professional fees for payroll and tax preparation.
• Health insurance rules: the IRS explains that health premiums paid for a more-than-2% shareholder-employee are included in wages in box 1 of their Form W-2, though not in the Social Security and Medicare wage boxes when certain conditions are met.

These costs come out of any saving.

When it may make sense

The election tends to suit businesses that:

• have consistent profit well above a reasonable salary for the owner's role
• can handle, or pay for, payroll and an extra return
• expect that profit level to continue

It tends not to suit businesses with low or irregular profit, or owners who would rather keep administration minimal. Because the outcome depends on your numbers and your state, compare the full picture with a tax professional before filing.

Undoing it

An S election can be revoked, but there are restrictions on re-electing for several years afterwards. Treat it as a medium-term decision.

Where it fits

If you are still choosing a structure, start with LLC vs sole proprietorship and single-member LLC. The S election is a later step for an established, profitable business.

An S election can reduce payroll-style taxes on profit above a reasonable salary, but it adds payroll, a separate return and costs. Check eligibility, respect the Form 2553 deadline, set a defensible salary, and decide with real numbers.