If you are a self-employed, a sole proprietor, or structured as an LLC, you probably felt left out during this crisis, because corporations and W2 employees were prioritized ahead of you by the governments. It was easier for you to apply for unemployment as a W2 employee. And it was easier for corporations to apply for the SBA EIDL loan & advance, and the SBA PPP loan.
Advantages and Disadvantages of an S Corporation
If you are considering making the switch from your current small business structure to an S Corporation, here are some pluses and minus to consider when compared to simpler entities like a self-employed individual, a sole proprietor, or an LLC.
Advantages of an S Corporation
- Self-employment Tax Savings – You can pay yourself a reasonable salary which is subject to federal and state income taxes social security, and medicare. For any excess profit, you can pay yourself as profit distributions without paying social security and medicare taxes (aka, self-employment taxes).
- Expense Deduction – Having a separate entity with its own bank account and its own book makes it easier for you to fully deduct all the expenses without triggering an audit by the IRS.
- Retirement Planning – As a corporation, you can set up a SEP IRA which allows the corporation to contribute up to 25% of your compensation, up to $56,000 per year (in 2019). As an S Corp with just one employee or a married couple, with no other employees, you can set up a Solo 401(k) which allows you to contribute up to $19,000 per person (in 2019).
- Limited Liability – With a corporation, there is an extra layer of protection against your personal asset.
- Transferable – Easier to sell the business and transfer ownership since the corporation is already a separate entity.
Disadvantages of an S Corporation
- More paperwork – Unlike a self-employed individual, a sole proprietor, or an LLC, you have a lot more paperwork to deal with
- When you set up the corporation, there are a lot of filing and fees
- On a monthly or quarterly basis (e.g., payroll, FUTA and state unemployment benefits filing, employer’s quarterly federal tax return, etc.)
- On a yearly basis (e.g., employer’s annual tax return, annual corporation registration, business license registration and payment, corporate tax filing, W2/W3 filing, etc.)
- Some new taxes and fees – Although you save money on self-employment taxes, there will be some new taxes to pay
- Corporation annual registration fee
- Business license fee
- Business property taxes
- Unemployment benefits taxes, i.e., FUTA and your state unemployment
- Business income tax preparation fee, i.e., 1120S filing fee
When Does It Make Sense to Become an S Corporation
For most people, the main financial benefit of being an S-Corp is tax savings, specifically the self-employment tax which is 15.3%. Remember that you’ll be paying extra costs and taxes to run an S-Corp. Here are some of the main ones that I am paying on a per year (you will have to research your own numbers to make the calculation)
- Payroll processing ~$600
- 1120S Corporate Tax Filing Fee ~$500
- State corporation registration fee ~$100
- State unemployment tax ~$20
- Federal unemployment ta ~$85
- County Business License Fee ~$675
- County Property Taxes ~$65
In total, I am paying about $2,045 to run my business as an S-Corp. This means that I have to save at least that much in self-employment taxes to break even. For my specific example, if after I pay all the expenses and a reasonable salary to myself, my corporation can still distribute at least $13,500 in profit distribution, then I am breaking even. If my corporation can distribute more than that consistently, year-after-year, then it is definitely worth running the business as an S-Corp.
For example, if you take an owner’s draw of $100,000 per year from your business, you’d pay $15,300 in self-employment taxes. If you switch to an S-Corp and pay yourself $50,000 per year and take a profit distribution of $50,000 per year (the same $100,000 as before), you’d only pay $7,650 on your salary, but not on the distribution — a saving of $7,650!
How to Set Up an S Corporation
The information below will be accurate at the federal level with specific examples for Virginia. If you’re incorporating outside of Virginia (you can incorporate in any state), or if your principal place of business is outside of Virginia, you will have to research your specific state and county requirement.
1. Select an appropriate name for your business
When you select your business name, be sure it complies with your state’s rules regarding S-Corp business names. The main part of the business name is generally flexible, but each state does have guidelines concerning prohibited letters and words. Also, the name must include the word “company,” “corporation,” “incorporated,” or “limited,” or the abbreviation “Co.,” “Corp.,” “Inc.” or “Ltd.”
For Virginia, here are the business entity names FAQ and Check Name Availability tool to help you identify a suitable name for your corporation. To be safe, you want to check the USPTO Trademarks Database to make sure you are not using a name that could land you in court.
Once you find the name you want, follow the instruction on the State website to
- Register the new business entity
- File the Articles of Incorporation
- Appoint a Registered Agent
2. Apply for an Employer Identification Number (EIN)
Next, head to the IRS website (be careful not to go to a third-party website) and apply for your Employer Identification Number (EIN). You will need the EIN for all of your future filings. The EIN is basically the Social Security Number for your S-Corp.
3. Submit Form 2553, Election by a Small Business Corporation
Form 2553, Election by a Small Business Corporation registers your business as an S-Corp for tax purposes in the eyes of the IRS.
4. Register for Business Licenses
Depending on the type of business you are running, you may require to register for a business license at the State, County, and/or City level. For example, my Virginia real estate business requires both:
- At the State level, I had to file a Business Entity License with the Department of Professional and Occupational Regulation.
- At the County level, I had to file a Business, Professional and Occupational License (BPOL) with Fairfax County where I reside.
For both, I have to pay an annual tax and/or a license renewal fee. Since this varies from location to location, you will have to do a search to find out exactly what you need to do.
5. Set Up a Business Checking Account
Next, you want to set up a business checking account with your local bank. You want an account dedicated to your business that is entirely separate from your personal accounts. All the business income and expenses will be run through this bank account. You will need your Articles of Incorporation and EIN number from steps #1 and #2 above to open a business checking account. In addition to your checks, you will be provided with the ABA routing number and the account number. You will need these for the next steps.
6. Register Tax Payment Accounts
Once you have your banking information, you will need to set up tax payment accounts.
- For the IRS, you will set up an account at EFTPS.gov. This is where you will be making your federal taxes, Social Security, Medicare, and FUTA deposits here.
- For State and Local taxes, you will have to do your research and find the appropriate website and/or process to follow. For Virginia, you can register an account at Virginia Tax Online Services for Businesses.
7. Set Up Your Book
Now you have to start keeping track of all your business income and expenses. This can be as simple as an Excel spreadsheet or you could use a business accounting software. Personally, I am using a simple Excel spreadsheet to keep track of everything for my own businesses. For another business that I used to work for, we used Quickbooks while I was running that business.
If you’re uncomfortable with this step, you could also hire a bookkeeper to help you set up and/or manage your book.
8. Set Up Your Payroll
To get the full benefits of the S-Corp, you want to set up a payroll. You can do this manually by writing yourself a monthly or a quarterly paycheck, and submit tax payments through the tax payment accounts you set up in Step #6.
If this is too overwhelming, you can ask your bookkeeper to manage your payroll as well, or you can hire a payroll services company to do the work for you.
9. Set Up Your Retirement Account
If you want to maximize your tax savings you need to set up the right retirement account for your situation. This usually means either a SEP IRA or a Solo 401(k). Again, you can do your own research to determine the best retirement account for your specific situation, or you can talk to an advisor, e.g., a tax advisor, a business consultant, other business owners, etc. to help you decide the best option.
In a nutshell, Steps #1 through 8 are the steps you need to convert your status from a self-employed individual or sole proprietor to an S-Corp. If you already have an LLC, most of these steps are already in place, but you still have to file the changes to the appropriate authority. Steps #9 is optional, but it helps maximize the benefits of an S-Corp.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.