When does an S-corp election start to make sense?

What actually changes

If you run your business as a sole proprietor or a single-member LLC, your net profit is subject to self-employment tax. That tax is 15.3%: 12.4% for Social Security and 2.9% for Medicare. It generally applies to 92.35% of your net earnings from self-employment.

After an S election, the business pays you a salary through payroll. Social Security and Medicare are paid on that salary: 7.65% by you and 7.65% by the business. The profit left after your salary can be paid out to you as a distribution, and distributions are not subject to Social Security and Medicare tax.

Income tax does not go away. The profit still passes through to your personal return. What changes is how much of it is hit by the 15.3%.

A worked example

That gap is the whole case for the election. Now subtract what an S corporation adds: running payroll every pay period, a separate business return (Form 1120-S), more bookkeeping, and any state or city tax on S corporations where you operate. If the gap is small, those costs can eat it.

The rule that decides the answer: reasonable salary

The IRS says an S corporation must pay reasonable compensation to a shareholder-employee for their services before it makes non-wage distributions. This rule limits the obvious shortcut of paying yourself a very low salary.

The IRS lists the factors it looks at, and they work well as a checklist:

• Your training and experience
• Your duties and responsibilities
• The time and effort you put into the business
• The company’s dividend history
• What it pays employees who are not shareholders
• The timing and manner of bonuses
• What comparable businesses pay for similar services
• Compensation agreements
• Any formula used to set pay

In the example, a higher reasonable salary means a smaller saving. That is why the salary is decided first, and the saving is worked out second.

Can your business elect?

Under the Form 2553 instructions, the business must be a domestic corporation, or a domestic entity eligible to be treated as a corporation, such as an LLC. It can have no more than 100 shareholders and only one class of stock.

The shareholders can only be individuals, estates, and certain exempt organizations and trusts. A nonresident alien cannot be a shareholder. For founders who live outside the US, this alone often rules the election out.

An eligible LLC that files Form 2553 does not also need to file Form 8832 to be treated as a corporation.

The deadline, with a calendar example

Form 2553 is due no more than 2 months and 15 days after the start of the tax year the election should take effect, or at any time during the year before.

Filed late without relief, the election generally takes effect the following year. The instructions describe relief for late elections under Rev. Proc. 2013-30; a late election filed that way says “FILED PURSUANT TO REV. PROC. 2013-30” at the top.

The IRS should generally send its decision within 60 days. If you hear nothing within 2 months of filing, the instructions say to follow up by phone.

Common mistakes

• Taking distributions with no salary, or a token salary, after electing.
• Electing without counting the cost of payroll and the separate business return.
• Missing the March 15 date for a calendar-year business and assuming the election still applies to this year.
• Filing without every shareholder’s consent: all shareholders must consent, and an officer signs the form.
• Electing when a shareholder is a nonresident alien, which makes the business ineligible.

Where to start

Bring last year’s profit and this year’s estimate. In a Strategy Session we set a defensible salary first, then compare the two sets of numbers, including the costs, before anything is filed.