Deciding whether to switch to an S Corporation isn’t a straightforward decision. There are three main upsides to making the switch, and four main downsides to making the switch.

First, you can reduce your taxes by eliminating self employment tax. When taxed as a proprietor or partnership, the IRS requires all of your wages to be subject to the 15.3% SE tax. As an S Corporation, you will be required to pay payroll taxes of 7.65% employer and 7.65% employee portion, so they can be just as bad as self-employment tax. However, if you make a reasonable argument to make your wages lower than all of the company profit, and take the rest as distributions, you will save on taxes.

Second, there are some audit protections. Every tax return is subject to IRS scrutiny, but the IRS has been less interested in auditing S Corporations compared to proprietorships.

Third, if done correctly, there may be more liability protections. When determining the liability of an owner in an LLC, the IRS will evaluate the formalities surrounding the business. Because the S Corp tends to have its own tax return, board meetings, and shareholders; if they are properly structured and maintained, they can have an advantage.

The downsides of having an S Corporation include the following:

  • Filing a form 1120-S: Even the simple S-Corp returns will cost $800-$1200 to file.
  • Payroll requirements: Even running quarterly payroll for 1 employee could add an extra $500-$1,000 of expenses!
  • Bookkeeping: When filing the form 1120-S, the IRS requires a balance sheet, which includes owner’s equity accounts, unlike the proprietorship. The business will usually need to buy Quickbooks (or a comparable program), hire a bookkeeper, get training, or prepare to have higher tax prep fees for getting the books cleaned up by the tax preparer so the cash balances tie to bank statements, the payroll agrees to payroll reports, and the balance sheet balances.
  • S election: If you are an LLC, you will either need to someone prepare the form 2553. It usually costs about $250 to have us file this. If you were to request a lawyer to set you up as an S Corp without the LLC in place, it would cost much more.

Consequently, I usually recommend a business should wait until they net around $40,000, that is, they are paying $6,120 of SE tax, before considering the change.