When should I set up my business as an S-Corp. It’s a common question and something that you should take careful thought before doing. There are benefits to setting up your business as an S-Corp but sometimes the rules and responsibilities may outweigh the benefits. We will discuss the pros and cons here so you can decide whether an S-Corp is right for you.

An S-Corp is a tax structure that may allow a business owner to save on Social Security and Medicare taxes. Social Security and Medicare account for 15.3%. The employer pays half and employee pays the other half.

How Do I Become an S-Corp

Setting up your business as S-Corp is not something that just happens automatically. If you create an LLC for your business, and you’re the only owner, then you are a sole proprietor. A sole proprietor files a Schedule C and reports his or her earnings as part of their individual income tax return. An entity must make an election, or request, to be taxed as an S-Corp. Form 2553 is the document that needs to be submitted to do so.

The IRS will then send you a letter if the request is accepted. At that point you will have to start filing a separate tax return for the S-Corporation and paying yourself a reasonable salary on the earnings you take from the business. The salary is paid through payroll so you essentially become an employee of your own business. On top of that you will need to follow the rules and regulations of being an S-Corp which means you:

  • Have no more than 100 shareholders
  • Have individual shareholders who are U.S. citizens or U.S. residents (trusts and estates may also qualify)
  • Be a domestic corporation
  • Have only one class of stock
  • Take profits and losses must be distributed in proportion to the owners’ interest percentage

You need to make the election, or request, to allow your business to be taxed as an S-Corp. This is done by submitting Form 2553 to the IRS. If your request is granted the IRS will send you an S-Corp acceptance letter to confirm. The federal confirmation will allow you to be treated as an S-Corp by most states. However, some states such as New York, require that you make a separate election on the state level to be taxed as an S-Corporation.

When Does it Make Sense to Become an S-Corp

If you understand the requirements and still want to become a S-Corp you first have to make sure that you are earning enough income. It is not uncommon for business owners to be in situations where it doesn’t make sense to set up an S-Corp because the business is just getting started and isn’t yet profitable.

EXAMPLE: Stanley is an electrician who decides to strike out on his own. He sets up an LLC and earns $40,000 in his first year while working full-time and now wants to know whether he should do this S-Corp election to save taxes.

Stanley has to consider whether he can draw a reasonable salary that is less than what he takes from his business. A reasonable salary is determined by what it would take to hire someone of his skillset and experience to do his job. He must also consider whether there is enough profit available to absorb the additional administrative costs involved with keeping books, drawing a salary and also filing required payroll tax returns.

EXAMPLE #2: Stanley determines that $90,000 is a reasonable salary for a similar electrician in his area. In his second year things really start rolling for him and he makes $160,000 in profits. In this case an S-Corp can benefit him. Instead of paying Social Security and Medicare on $160,000 he only pays it on his salary and shields $70,000 from taxes ($160,000 – $90,000).

Each person’s tax situation is unique. Consider all factors and be sure that you earn enough so that it makes sense to set up your business as an S-Corp.

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