Starting An S Corp? These Four Questions Will Help You Decide
Do S corps really live up to the hype? Even though everyone else is forming one—should you? How do you know if it’s really worth the time and investment?
The truth is every business is different, forming an S corp is a decision that you should make with consideration and care. While you should always consult a legal & financial advisor about your legal structure, there are some early questions you can ask to see if you’re ready to consider forming an S corp.
But first…
How does an S corp work?
If you haven’t heard of S corps yet, here’s a brief rundown of how they work. Like sole proprietors and partnerships, S corps are pass-through entities. Therefore, the company owner reports the business income on their personal tax return.
Unlike sole proprietors, LLCs, and partnerships, however, the income passed through from an S corp is not subject to self-employment tax, which amounts to 15.3%. The owner only pays income tax on their business’s income.
S corps are required to pay their owners a “reasonable compensation” through payroll. That means that you, the owner, will be an employee of your business.
You personally and your business will pay FICA taxes, which is withdrawn from every paycheck. In other words, you are paying the equivalent of self-employment tax on your salary.
How much you pay yourself depends on your industry and tax strategy, but you do have to pay yourself. If not, it looks like you’re abusing the S corp taxation structure and using it to avoid paying self-employment tax on your business income.
If you are paying yourself a reasonable compensation, which is a tax deduction for your business, whatever profit your business makes is not subject to corporate taxation or self-employment tax.
That’s where S corps really shine.
Now that you know how this entity works, here are four things to ask yourself when starting your business:
1. Can your business cover the additional costs?
When you form an S corp you have additional monthly and annual costs, before forming your business make sure that you can pay for these costs.
Monthly:
- Owner’s salary: This amount will vary depending on how much you pay youself.
- Payroll taxes: FICA taxes are 7.35% of your annual salary. FUTA taxes are 6% on the first $7,000 that you earn.
- Payroll processing fees: The cost varies by the payroll provider, but you can expect to pay at least $90 per month.
Annually:
- Tax preparation fees: Your S corp will now need to file its own tax return, and you will still need to file a personal tax return.
- Annual state fees: Most states require that you pay an annual fee for your business entity. The fees vary state by state, ranging from $10 to $800.
Additional costs may include bookkeeping services & insurance depending on which state you are in. Finally, you will also have the cost of forming your S corp, which includes state filing fees and legal fees if you’re using a filing service.
2. How much taxable income do you have?
One of the primary reasons business owners form S corps is because of the tax savings potential. However, not everyone benefits from forming an S corp.
In some cases, the cost of forming an S corp, running payroll, and paying payroll taxes is more than what you’d save on taxes. Other times, after the expense of the owner’s salary, the business’s net income is so low that the tax savings are minimal.
So how much money do you need to make for this to benefit you? There’s a lot of opinions, it can range from $45,000 to $70,000 in taxable income. So if your business is making $60,000 in profit every year, then you should look into forming an S corp.
Keep in mind that we’re talking about taxable income, not gross revenue.
- Your gross revenue is all the money you make from your products and services.
- Your taxable income is your revenue minus your tax deductions. Essentially, it’s the profit from your business.
3. How consistent is your cash flow?
The most common struggle with newly formed S corps is that there isn’t enough cash flow to cover payroll. Remember, you’re not only paying the owner’s salary, you’re also paying payroll taxes.
On the employee side, your take-home pay is what’s left after your portion of taxes is withdrawn from your paycheck. Meaning, you may need to increase your salary or take an additional distribution to cover your living expenses.
Here’s an example:
As a sole proprietor, you draw $4,000 out of your business every month to cover your living expenses. Whereas, an S corp you have a monthly salary of $4,000. Your business pays $306 in payroll taxes and has to have enough cash to cover a $4,306 withdrawal.
You, the employee, also have $306 withdrawn from your paycheck plus federal and state tax withholdings. What you receive may be closer to $3,200. Therefore, to cover living expenses you need to take an additional $800 distribution from your business. That means there needs to be $5,106 in the bank to cover your monthly payroll costs and distribution.
4. Do your long-term business goals include investors or partners?
Before you go all in on, consider your long-term business goals:
- Where do you see your business three to five years from now?
- Do you plan on looking for investors?
- Do you foresee getting acquired by another business?
- Will you want to add a business partner?
These are important questions to ask yourself before forming your business.
S corps cannot have more than 100 shareholders. Only US citizens or permanent residents can be owners and investors and the allocation of S corp income or losses is based on stock ownership. Meaning, if you own 50% of the S corp, you’re automatically allocated 50% of the business’s income.
This allocation happens regardless of whether you’ve paid out dividends to your shareholders. That means if you have a silent partner, they will be taxed on the business income based on the percentage of the business that they own. This is different than an LLC, which can allocate income and losses based on an operating agreement.
S corps can only have one class of stock. However, you can have voting and nonvoting stock, which helps widen the possibilities of bringing on additional owners. But it still makes working with investors trickier than a standard LLC—and you would need to hire a lawyer, adding to your costs.
Finally, an S corp cannot be owned by a corporation or a partnership. That means if another company wants to purchase your business, you will need to change your entity structure, which can make it more difficult to find investors.
Before forming an S corp, get clear on your long-term business goals, if you think you’re ready for an S corp, consult a tax and legal advisor about your unique situation. Who knows? In just a few months you could be saving thousands of dollars on your taxes.