Question from a client who was thinking about starting a side business: At what point should I look at forming an S-corporation?
The first thing to understand about S-corps is, why do people form S-corps?
S-corps allow people to save on self-employment/FICA tax. Here’s an example:
As a sole proprietor, you’d pay income tax and self-employment tax on your net income from your business. So if you have $10,000 of net income, you’re paying income tax AND SS/Med tax on $10,000.*
(*-Side note for the tax geeks in the crowd: technically the SE tax is paid on 92.35% of the net income, but in my response to my client I omitted that part so as not to make their eyes completely glaze over.)
With an S-corp, you’d pay yourself a salary, and that salary would have FICA taxes withheld on it. Any remaining profit from the business is subject to income tax but NOT FICA/SE tax.
Say you’re an S-corp with net income of $50,000. You decide to pay yourself a $20,000 salary. The 20K is subject to income tax and SS/Med tax. The remaining $30,000 is subject to income tax but NOT SS/Med tax.
While this sounds like a tax savings bonanza, there are a few cautions:
- The salary you pay yourself must be “reasonable” for the work you do in the corporation. Obviously, it’s smart to set the salary as low as possible, but it must be a defensible amount. The IRS does audit this issue.
- Paying a salary to yourself means setting up payroll, dealing with 941s, etc. Whether you do it yourself or you pay me to do it, there’s a cost of either professional fees or your time and headaches in dealing with this stuff.
- You must file a corporate tax return for the S-corp, which means additional fees and compliance headaches.
- In my experience, many people form S-corps way, way too soon, and then get mad because the tax savings end up not being worth the hassles and headaches.
So, when do you do an S-corp?
You should look at becoming an S-corp when your net income from the business starts to approach the amount of a “reasonable salary” for the work you do.
As mentioned in item 4 above, in my experience, many sole proprietors form S-corporations way, way, way too soon. Then they get upset and overwhelmed with all the things that come with being an S-corp. For further reading on this subject, check out this blog post.