S-Corp Answers

You've got S-Corp questions.
I've got S-Corp answers.

Danny Nelson, EA

based in Anderson, SC

If you don't see answers to your questions below, please email your question to danny@stewardshipos.com or Schedule A Free Conversation with me.

Q: What is an S-Corp?
A: An S-Corp starts off as either a “regular” corporation OR an LLC and makes an election with the IRS to be taxed differently.

Regular corps and LLCs are taxed their own ways according to rules set at the federal level. When they elect to be S-Corps, they are taxed according to other rules set at the federal level.

Most states have their own rules for how S-Corps are treated differently than regular corps and LLCs as well.

Q: How do S-Corps reduce my taxes?

A1: Let's say you're an LLC taxed as a sole proprietor OR an LLC taxed as a partnership. Under this arrangement, ALL of your profits are subject to both income tax AND self-employment tax.

Making an S-Corp election in this situation can reduce the amount of profits subject to self-employment tax.

This can result in huge tax savings under the right conditions. In other situations it can have no effect or even increase taxes.

A2: Let's say you have an Inc. or LLC taxed as a “regular” corporation. Under this arrangement, ALL of your profits are taxed at the corporate tax rate and any distrubutions of profits (dividends) you receive from your corporation are taxed on your personal return.

Thus, your profits are taxed twice… once at the corporate level, and again at the personal level when distributed.

Making an S-Corp election in this situation can reduce taxes by eliminating the corporate tax and dividend tax. Instead, all of the profits are taxed ONCE on the shareholders' personal returns at their tax rate.

Again, this can result in huge tax savings under the right conditions. In other situations it can have no effect or even increase taxes.

Click here to get an S-Corp Analysis

Q: What's the catch?
A: S-Corps do have some restrictions that don't apply to “regular” corps, partnerships, and sole proprietorships. Here are a few…

1. Generally, number of shareholders limited to 100.

2. Generally, all shareholders must be US citizens.

3. Only one class of stock is allowed.

4. Distributions of profits and losses must be made based on ownership percentage.

5. Owners (shareholders) that work in the business must be paid “reasonable compensation” for their services before distributions can be made to them.

See the question below, What is “Reasonable Compensation”?

Click here to get an S-Corp Analysis

Q: How do I get my business to be an S-Corp?

A: You make an election!

Use IRS Form 2553 to make the election.

Click here to get an S-Corp Analysis

Q: What is "Reasonable Compensation"?

A: This is a question that is easy to over-complicate and to over-simplify.

For the purpose of understanding what it means for your S-Corp, reasonable compensation is the wage/salary that must be paid to shareholders who provide services or “work” for the S-Corp.

A lot of people get hung up on the word reasonable. The easiest way to explain what reasonable means here is to ask yourself (as the shareholder who works in the S-Corp), “what would I pay somebody to do my job AND what would somebody accept to do my job?”

Think of it as a salary that would be negotiated in an arms-length transaction between two willing parties.

That is a good framework for understanding what reasonable compensation is, but it doesn't help you settle on an actual number.

For help on actually calculating reasonable compensation, see the next Question below.

Click here to get an S-Corp Analysis

Q: How do you calculate "Reasonable Compensation"?

A: Most S-Corp employee shareholders wear multiple hats in their business. Think about a typical 40 to 50+ hour week that you work. You likely spend time in some of these categories:

  • secretarial
  • accounting/bookkeeping
  • supervision
  • human resource management
  • janitorial
  • customer service
  • etc.
  • Oh, and then there's the thing you are actually trained to do and are in business for.

For purposes of calculating reasonable compensation, assume a 40 hour work week. I know, you don't work 40 hour weeks, but work with me.

Here is how you do the actual calculation…

  1. Allocate your hours among the various hats you wear.
  2. Find the wage calculated by the Bureau of Labor and Statistics for each category (hat) for your geographical location and your level of competency in each category.
  3. Multiply the BLS wage by the number of hours you work in each category per week.
  4. Add up all of the weighted wages and multiply by 52.

OR… find a willing accountant and pay him or her to do this calculation for you.

Click here to get an S-Corp Analysis (includes up to 2 Reasonable Compensation Calculations)

Q: How does electing "S" status affect my "Qualified Business Income Deduction"?

A: It changes it.

For a refresher on what the QBID is, please see the question directly below this one.

When comparing a Schedule C business to an S-Corp “apples to apples” the QBID is generally lower for S-Corp shareholders than for Schedule C sole proprietors. This is because the owner/employee wage deduction in an S-Corp reduces the business income that is eligible to be used for calculating the QBID.

The QBID is currently set to expire after the 2025 tax year unless Congress acts to extend it.

The QBID is a factor that many accountants ignore when analyzing the benefits of an S-Corp election. This is because they didn't have to consider it before 2018 when it was created and they sometimes assume that it won't make that much of a difference anyway.

This is a costly mistake!

I have seen scenarios where the QBID has a significant effect on the S-Corp tax savings and was a deciding factor in deciding whether or not to make the election.

Needless to say, I take the QBID into account when doing an S-Corp Analysis.

Click here to get an S-Corp Analysis

Q: What is a "Qualified Business Income Deduction" (aka QBID)?
A: In simple terms, the QBID is a deduction taken by business owners on their personal tax return that is calculated by multiplying business income by 20% (subject to limitations, of course).

So, if your Schedule C net income is $100,000, your tentative QBID would be $20,000. One of the limitations is that the QBID can't exceed 20% of taxable income without regard to the QBID. Unless there is significant other income, taxable income would be less than buisness income and so QBID in this case would be less than $20,000.

QBID limitations must also be taken into account when doing an S-Corp Anlysis. I do that.

Click here to get an S-Corp Analysis

Q: How can I know if an S-Corp election will ACTUALLY reduce my taxes?

A: Your particular situation must be analyzed as though your business were an S-Corp. Then the results of that analysis must be compared to the results of your current situation.

How do you do that?

Here it is broken down into 5 steps:

1. Do a reasonable compensation calculation for all owner/employees.

2. Run a tax return scenario where your Schedule C sole proprietor income is S-Corp pass-through income (reduced by your reasonable compensation) and your wages are increased by your reasonable compensation.

3. Review the QBID to make sure it is being calculated correctly and that limitations are properly applied.

4. Compare the Federal and State tax results to see if there are tax savings from the S-Corp.

5. Reduce those tax savings by additional compliance costs of electing to become an S-Corp (cost of the S-Corp tax return, annual reasonable compensation calculation, AND the marginal cost of adding an employee to your payroll–this will be higher if you don't have a payroll system in place at all).

For most business owners, this task is oursourced to their accountant. It doesn't mean you can't do it, but it might save you some time and angst.

I have an S-Corp Analysis service where I do all of this for you.

Click here to get an S-Corp Analysis

Q: What are the additional costs of becoming an S-Corp?

A1: The following are some potential additional non-tax costs that should be considered when considering an S-Corp election…

  • (optional, but probably advisable) An analysis to find out if an S-Corp election will actually save you tax dollars.
  • (optional, but probably advisable) Annual Reasonable Compensation Calculations
  • The marginal cost of your accountant preparing an S-Corp tax return (Form 1120-S) rather than a Schedule C on your 1040 OR a “regular” corporate tax return (Form 1120).
  • The cost of processing payroll for the shareholder employees.

Click here to get an S-Corp Analysis