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The Dirty Secrets of S-Corp Elections

business setup s-corp taxes Aug 01, 2023

The Dirty Secrets of the S-Corp Election

More & more, I see tax pro’s marketing the S-Corp election for massive tax savings but just like anything else, it’s important to do your homework before letting someone convince you that their way is the right way. It’s not a one-size fits all, and in this article I’m going to share some of the drawbacks (dirty secrets) about S-Corps plus what you can expect to pay for various services associated with electing S-Corp status.

First, though,

What’s an S-Corporation vs S-Corp Election?

An S-Corporation, or S-Corp, is a selected business structure, that one would choose at the time of forming their company. Choosing this structure allows pass-through taxation, meaning that profits and losses pass through to shareholders' personal tax returns, avoiding double taxation (i.e. the business being taxed AND you personally being taxed the income you pay yourself from the business).

On the other hand, the S-Corp election refers to the process of choosing S-Corp status for a business that is already established as a C-Corp or LLC. you can chose to be taxed as an S-Corp after you’ve already formed your business as an LLC or C-Corporation. Which is pretty handy if you start making some real money down the road and you’re ready to implement savings strategies.

BUT, while S-Corps offer certain tax benefits, they also come with potential drawbacks, which we’re going to dive into today:

1. Cost of Payroll

One significant drawback of S-Corp status is the cost of hiring a payroll provider (we recommend Gusto!). As an S-Corp, you're required to pay yourself a reasonable salary, which means setting up a payroll system & maintaining it—running payroll each month & setting everything up. This adds administrative overhead and expenses for payroll processing, tax withholding, and other fees associated with staying compliant in your state. For small businesses with limited time & cash flow, this can be a burden.

💸 You can expect to pay at least $45+/mo for a payroll provider like Gusto.

2. Tax Prep + Bookkeeping Fees

As mentioned above, you’ll have to make sure you’re paying yourself a reasonable salary—which means, you’ll either have to send the time researching & analyzing this or paying someone else to figure it out for you. Most likely you’d have a tax pro help you establish this and write a memo/support for you to keep on file, should you ever get audited. If you’re working with a tax-pro who is pushing you to elect S-Corp status but isn’t including the reasonable compensation calculation in their service package, I recommend working with someone else.

💸 You can expect to pay anywhere from $800 - $2500 per year for the tax prep & strategy services.

You’ll also need to make sure your bookkeeping is in tip-top shape throughout the year, so your tax pro can use your numbers to strategize but also because the tax forms will require more detailed information from your bookkeeping, like a Balance Sheet (which isn’t required for Schedule C filers). For this, its really important to use an accounting system + a bookkeeper who truly understands accounting to keep you compliant.

💸 You can expect to pay anywhere from $350 - $650 for basic monthly bookkeeping.

3. Keeping Monthly Board Minutes

Another unique obligation of S-Corps is the need to hold regular board meetings and maintain detailed minutes of these meetings. These minutes should document:

  • major business decisions,
  • changes in ownership,
  • and other relevant matters like financial performance

While this ensures corporate governance and legal compliance, it can be an added administrative burden for business owners, demanding more time and effort. If you already have a monthly management / leadership meeting, you can just document those meetings. If you work with a bookkeeping firm like ours, some of our packages offer monthly meetings where we go over these topics and can keep minutes for you.

💸 You can expect to pay upwards of $650 - $1000 per month for bookkeeping that includes this service.

4. Cash Flow Considerations

Electing S-Corp status may not be financially viable for businesses with limited or inconsistent cash flow. Many tax savings strategies available to business owners require healthy cash flow to be able to really take advantage of them, which requires a different level of discipline. Unlike other business structures, S-Corps require owners to pay themselves a reasonable salary, subject to payroll taxes, even if the company is not generating substantial profits. This could could be difficult to sustain in businesses in their early stages or during periods of low profitability (think seasonal businesses).

5. Inability to Reverse for 5 Years

Once you elect S-Corp status, reversing that election requires waiting for a specific period before making a new election or reverting to its previous status. According to the Internal Revenue Service (IRS) regulations, the waiting period to make a new S-Corp election or revoke a previous election is generally five years. There are exceptions, but in general, this is the rule. So if you think your business may significantly decline or close down in the next few years, you may not want to elect S-Corp status.

Tax Savings Potential

Despite the drawbacks, there are compelling benefits to electing S-Corp status. S-Corps allow for pass-through taxation, meaning that profits and losses pass through to shareholders' personal tax returns, avoiding double taxation. Although, this can also be achieved with a Single-or Multi-Member LLC.

By paying yourself a reasonable salary and taking the remaining income as distributions, you can potentially minimize the overall tax burden. This tax savings potential can be great, especially if you’re making significant profits and have enough excess cash to be paying yourself consistently.

Comparison to Section 199 Small Business Deduction:

The Section 199 Small Business Deduction, also known as the Qualified Business Income (QBI) deduction, provides tax relief to pass-through entities, including S-Corps. But, not all types of business industries are eligible for this deduction. It allows eligible taxpayers to deduct up to 20% of their qualified business income. The S-Corp tax savings can be further enhanced when combined with the Section 199 deduction, potentially reducing the overall tax liability. However, it's important to consult with a tax professional to determine eligibility and evaluate the specific impact on your business.

When is S-Corp Better?

Electing S Corp status may be more advantageous in certain scenarios. If your business generates substantial profits and the potential tax savings outweigh the costs associated with payroll providers, bookkeeping, tax pro, and board minutes, an S-Corp can provide significant tax advantages. Additionally, if your business operates in an industry that is not eligible for the Section 199 deduction, or if you have employees and want to provide them with benefits, an S-Corp may be a more favorable choice. It's crucial to assess your unique circumstances and consult with tax and legal professionals to make an informed decision.

If we take a rough estimate based on the numbers above (annually), you’d want your tax savings from electing S-Corp status to significantly exceed the costs associated in order for it to be worth it—and don’t forget to calculate the time & headache involved!

Cost Example

Payroll Fees: $500
Tax Prep & Strategy: $2,500
Bookkeeping + Monthly Meeting Minutes: $12,000

Total Cost: $15k

You’d want to save at lease $20k in taxes for this to be worth it. (This example takes the higher end of the costs for demonstration purposes)

I hope this article has helped you understand the implications and the “dirty secrets” of S Corp status. Yes, there can be tax savings, but everything has an opportunity cost.

If you’re already an S-Corp & you need a bookkeeping team that has your back, fill out the interest form to get on our waitlist HERE.

(Note: it's always recommended to consult with professionals to get personalized advice based on your specific situation.)


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