To S-Corp or not to S-Corp—that’s the question! By now, you’ve likely heard about S Corporations on either YouTube or TikTok. Influencers praise S-Corps as a miracle tax-saving structure that’ll slash your tax bill. But is the hype real? And if it is, at what point does it make sense to convert to the S Corp?
To understand if an S Corp can benefit you, start by calculating its tax savings and comparing them to the accounting costs associated with running an S Corp. Once you know your tax benefits and costs, you can make a solid decision about moving towards the S-Corp status. In this blog, I will break down the main savings and costs of an S-Corp to help you make a more educated decision.
Professional Disclaimer: This blog mostly applies to sole proprietors with single businesses. Every situation is unique, and for some, an S-Corp might not be the best fit based on personal circumstances and the set up of their business structure.
Understanding S Corp Savings
The main benefit of an S Corp structure is its potential to reduce self-employment taxes. As a proprietorship or a single-member LLC owner (we talked about the differences between these two here), you pay 15.3% self-employment tax on the entire net income. With an S Corp, however, you pay yourself a salary that is a subject to payroll taxes, and then take the remaining income as distributions. That remaining income is not subject to self-employment tax. This income, however, is still subject to ordinary tax, but we won’t go into detail about this topic here.
Let’s break down this concept with an example:
You own a business. Your net profit (please note, by net profit in this particular case, we mean all receipts minus all expenses) is $80,000.You decide to issue yourself a W-2 for $40,000.
In an S Corp, only the $40,000 salary is subject to payroll tax. At 15.3%, this results in $40,000 × 0.153 = $6,120. In a sole proprietorship, you’d pay $12,240 in self-employment tax on the entire $80,000, since you can’t issue yourself a W-2 as a sole proprietor
So, by moving into the S Corp and issuing yourself a W-2, you could save: $12,240−$6,120 = $6,120.
But keep in mind, that this is a very straightforward and simple calculation, and it is not entirely correct. There are many other factors that come into play when calculating S Corp savings. The big one is a QBI deduction, which in some cases (but not always) will reduce S Corp tax savings, but there are many other factors. Most of the S Corp calculators we see on the internet do not add other factors into their calculation formula. The most precise calculator we found is on the Intuit’s website. When using Intuit’s calculator, you need to compare "Schedule C/F" and with "S Corp K-1" and look at the “Total Cash After Taxes” row. This calculator tends to work well only for single-owner business calculations, and you can get a rough idea of your after tax cash inflow. However, If you have multiple owners or income streams, speak with a tax professional before making the S-Corp jump as this calculator does not cover all tax scenarios.
Understanding S-Corp Costs
Once you’ve estimated your tax savings, it’s time to dive into the costs. Each state has different costs associated with legal formation. Since our CPA firm focuses on California, we will include typical California costs.
- Payroll Costs
Payroll Costs: An S-Corp requires payroll—even if it’s just for yourself. Payroll services typically cost $500–$600 per year. - Tax Return Filing Costs
Filing Form 1120S usually costs between $750 and $3,000, depending on the complexity of your tax return and the accounting firm you hire. - California Franchise Tax
California S-Corps pay an $800 franchise tax, regardless of income. It is a fixed fee. - California S Corp Tax (1.5% of Net Income)
California also imposes a 1.5% tax on the S Corp’s net income. Yes, California double-taxes S Corps, and we explain this in detail here. In short, If the net profit of your S Corp (in this case, meaning all gross receipts minus all expenses, including your W-2) exceeds $54,000, the FTB will collect additional taxes on your S Corp. If your net profit is less than $54,000, you will be paying only an $800 flat fee. - Cost of Accounting Software
Oh, this is a tough one since it is a variable cost that allows some flexibility. If your gross receipts or assets exceed $250,000, you’ll need accounting software that does bank reconciliations. We explained the reason for it here. To give you a ballpark number, QuickBooks Online starts at $35/month, while Xero is about $20/month, making the average yearly fee for the accounting software around $300. If your gross receipts are less than $250,000, you can get away with accounting on Excel and then have your accountant true up things for you on your S Corp tax return. But again, what CPA will do accounting work for free? Most likely your CPA will charge you extra for this type of work and whatever you saved up on the accounting software will end up in the CPAs’ pocket. - Cost of Bookkeeping Help
This is another variable. If you can’t handle bookkeeping yourself, you may need to outsource it to a bookkeeping firm. For a small S Corp, bookkeeping services can range from $100 to $600 per month, depending on complexity. Assuming an average monthly cost of $300, this translates to an additional $3,600 per year. If you decide to do accounting yourself, in most cases it will need final adjustments and the CPA may still charge you extra for fixing your imperfect books.
Now Let’s Add Up S Corp Average Accounting Costs:
1. Payroll Costs: $600
2. S-Corp Tax Return Filing Costs: $1,500
3. California Minimum Franchise Tax: $800
4. Accounting Software: $400
5. Bookkeeping Help: $3,000
In total, running an S-Corp in California can cost about $6,300 per year, including bookkeeping. If you handle bookkeeping yourself, costs might drop to around $3,000 or so.
Comparing Savings and Costs
In our example, a small S-Corp with $80,000 in profit and $40,000 in shareholder salary could save you roughly $6,000 a year, but you would need to spend on its accounting upkeep anywhere from $3,000 to $6,000 a year.
And another consideration: if your careful cost-benefit analysis shows that an S Corp will save you $1,000, is this savings worth your time and potential accounting headaches? Managing accounting, payroll, and tax preparation is time-consuming unless you outsource it to someone else.
And of course, nothing is straightforward in tax. There are many circumstances when S Corp can be more or less useful tax wise besides savings on self-employment taxes.
For example, S Corp status might not be beneficial if you’re also employed and paying most of your self-employment taxes through your main job. When you’re an employee, your employer pays half of your Social Security and Medicare taxes, cutting your self-employment tax burden in half. This means you’re responsible for only 50 percent of those taxes. Plus, there’s a threshold on the income that requires Social Security taxes—it is $168,600 in 2024. So, if you’ve already paid Social Security taxes through your W-2, setting up an S Corp for a side business could be unnecessary and costly. While you can refund the employee portion of Social Security taxes on your personal tax return, the employer portion of the taxes paid through the S Corp is non-refundable and lost.
However, there are situations where an S Corp can be advantageous even if you’ve already met your self-employment tax obligation through a W-2 job. For example, in some states S Corps can facilitate Pass-Through Entity Tax (PTET) payments. An S Corp can pay for your personal state taxes and deduct these personal taxes as a business expense. While you may lose out on the Social Security tax, PTET savings could offset this loss. We discussed a PTET case here.
There is another issue that may affect the profitability of your S Corp, and it is the QBI deduction we mentioned above. Depending on the amount of your reasonable compensation, the QBI deduction may take away tax savings. But with more profitable S Corps, QBI can actually help generate an additional deduction. QBI is a more advanced tax topic, and if you want to learn more about it, you can read about it here.
Now let’s go back to our cost analysis. The cost of an S Corp can be significantly reduced when a business owner already has an LLC for legal purposes and pays the $800 minimum franchise tax just for legal protection. The same owner already spends money on the accounting software to keep track of their profits. In this scenario, their S Corp costs are much lower. Instead of moving from zero dollars to $6K in accounting costs, the business owner only increases their accounting spending by adding payroll and S Corp tax preparation costs. This is a natural progression in the business growth cycle and, in most cases, it does not overwhelm the business owner, since they have time to figure their accounting and LLC responsibilities before jumping into the S-Corp tax return and payroll filings.
So, when does it make sense to transition from an LLC to an S Corp?
When someone claims you can save money with an S Corp on a $40,000 net profit, it’s often misleading, as it oversells the benefits without mentioning the associated accounting and legal costs. Based on the analysis above, California businesses should not convert to S Corps until they hit the $80,000 in net profits.
In summary, please do your research or consult a trusted tax professional before converting to an S Corp. S Corps are indeed a tax efficient tool, but they may not be suitable for everyone due to accounting costs, personal circumstances or the structure of your business.
And now a bit of shameless self-promotion: if you’re curious whether an S Corp is the right fit for you, please reach out! We’ll review your tax situation and give you exact numbers on potential savings with an S Corp. And if you’re already an S Corp owner who is tired of handling finances yourself, check out our services here.