S-Corp Election: When It Saves You Money (and When It Doesn't)

What Is an S-Corp Election?

First, let us clear up a common misconception: an S-Corp is not a type of business entity. It is a tax election. You form an LLC or corporation, then you elect S-Corp tax treatment by filing Form 2553 with the IRS.

This means you keep your LLC's legal structure and liability protection, but change how the IRS taxes your income. The result, for many business owners, is a meaningful reduction in self-employment taxes.

How the S-Corp Tax Advantage Works

As a sole proprietor or standard LLC, you pay self-employment tax (15.3%) on your entire net business income. As an S-Corp, the math changes:

1. You must pay yourself a "reasonable salary" as a W-2 employee of your own company.
2. You pay payroll taxes (Social Security and Medicare) only on that salary.
3. Any remaining profit is distributed to you as an owner distribution, which is NOT subject to self-employment tax.

Example: Your LLC nets $150,000 per year.

• Without S-Corp: You pay self-employment tax on the full $150,000. That is roughly $21,200 in SE tax alone.
• With S-Corp: You pay yourself a reasonable salary of $70,000 and take $80,000 as a distribution. Payroll taxes apply only to the $70,000 salary, saving you roughly $12,200 in SE tax.

That is real money. But it is not free.

The Costs of S-Corp Status

The S-Corp election adds complexity and expense:

• Payroll processing. You must run actual payroll for yourself, including withholding, quarterly payroll tax deposits, and W-2 filing. Budget $500-$2,000/year for payroll services.
• Payroll taxes. The employer half of payroll taxes (7.65%) comes out of the company.
• Additional tax preparation. S-Corps file Form 1120-S, a separate corporate tax return. Your CPA fees will increase by $500-$2,000.
• Reasonable compensation scrutiny. The IRS watches S-Corp salary levels. Pay yourself too little, and they can reclassify distributions as salary and charge back payroll taxes plus penalties.
• State taxes. Some states impose additional taxes on S-Corps. California charges a 1.5% franchise tax on net income. New York City does not recognize S-Corp status at all.

When Does the S-Corp Make Sense?

The general rule of thumb: the S-Corp election starts making sense when your net business income consistently exceeds $60,000-$80,000 per year. Below that, the payroll and tax preparation costs eat up most or all of the tax savings.

The S-Corp is likely a good fit if:

• Your net income is consistently over $80,000
• Your business has relatively low capital needs
• You are the primary income earner in the business
• Your state does not penalize S-Corp status
• You are disciplined enough to run payroll consistently

The S-Corp probably is not worth it if:

• Your income is under $60,000
• Your income fluctuates wildly year to year
• You operate in a state with S-Corp-unfriendly taxes
• You plan to reinvest most profits into the business
• You want to offer equity to investors (S-Corps have ownership restrictions)

How to Make the Election

File Form 2553 with the IRS. The timing matters:

• For an existing entity, you must file by March 15 of the tax year in which you want the election to take effect.
• For a new entity, file within 75 days of formation.
• If you miss the deadline, you can file a late election with a reasonable cause statement. The IRS has been fairly lenient on late elections, but do not count on it.

All shareholders must sign the form consenting to the election.

Reasonable Compensation: The Critical Detail

The IRS requires S-Corp owner-employees to receive "reasonable compensation" for the work they perform. There is no fixed number or formula. The IRS looks at:

• What comparable businesses pay for similar work
• Your experience, training, and responsibilities
• The time and effort you devote to the business
• The company's revenue and profit history

A good benchmark: your salary should be at least 40-60% of your net income, and it should be defensible if compared to what you would pay someone else to do your job. If your company nets $200,000 and you pay yourself $30,000, you are asking for an audit.

Work with a CPA to set your salary. Document your reasoning. Update it annually as your business grows.

S-Corp Requirements and Restrictions

Not every business can elect S-Corp status. The rules:

• 100 shareholders or fewer (family members count as one)
• Only U.S. citizens and resident aliens as shareholders
• One class of stock (though you can have voting and non-voting shares)
• No corporate or partnership shareholders (with narrow exceptions for certain trusts and estates)
• Must adopt a calendar year as the tax year (with some exceptions)

These restrictions mean the S-Corp is designed for small, domestically owned businesses. If you plan to bring on investors, particularly institutional investors or foreign nationals, the S-Corp may not work.

S-Corp vs. C-Corp Taxation

In an S-Corp, profits pass through to your personal tax return and are taxed once. In a C-Corp, profits are taxed at the corporate level (21%) and then again when distributed as dividends (qualified dividends at 0-20%). This double taxation is why most small businesses prefer S-Corp treatment.

However, the 21% corporate tax rate under current law can make C-Corp status attractive for businesses that retain significant earnings for growth rather than distributing them to owners.

Common S-Corp Mistakes

• Not running payroll. Taking only distributions without salary is the number one audit trigger.
• Setting salary too low. The IRS will reclassify distributions and add penalties.
• Missing the filing deadline. March 15 is firm. Mark your calendar.
• Forgetting state requirements. Some states require a separate S-Corp election filing.
• Not maintaining corporate formalities. Keep minutes, hold annual meetings (even if it is just you), and document major decisions.

Bottom Line

The S-Corp election is one of the most effective tax strategies for profitable small businesses. But it is not for everyone, and it is not free. Do the math with your CPA, factor in the compliance costs, and make sure the tax savings genuinely outweigh the hassle. For contractors and service businesses consistently earning over $80,000, it usually does.