Introduction to S Corps

We outlined the basics for S Corporations in the Business Entities section, but understanding the advantages and disadvantages of operating an S Corporation can be challenging. Let’s review the business structure and then take it through an example in two different worlds. (Fiction writers, I know you’re with me here.)

An S Corporation must:

  • file articles of incorporation with the state and pay a filing fee. Examples and templates can easily be found on Secretary of State websites or third party legal sites.
  • obtain an employer identification number from the IRS by filing Form SS-4. (You’ll be an employee of the S Corp, so the company needs an employer number.)
  • file an “S” election with the IRS by March 15th of the tax year in which you wish to claim the S Corp status. This is done on Form 2553.
  • elect a board of directors (the required number of directors varies by state) who will appoint management to run daily operations. You can appoint yourself chairman of the board and insist on the title for every occasion. (“Kindly pass the asparagus, Madam Chair.”)
  • follow corporate formalities. This includes adopting bylaws (a document governing how your company will operate) and holding regular meetings (at least annually) that are duly recorded.
  • keep separate accounts. A company bank account is an absolute necessity.
  • decide whether to process payroll in-house or hire a service. Separate state and federal payments and filings are required throughout the year for payroll and many single-employee S Corps find it easier to outsource this task. Expect to pay around $500 a year for a payroll service.
  • set a reasonable salary for its employee. This is the key point for tax planning and often the trigger for IRS audits. Let’s break it down…

What is a Reasonable Salary?

A salary is the amount you, the employee, are paid in wages from the S Corporation. This is the amount running through the payroll and the basis for your W-2 at the end of the year. As the sole employee (in most cases) who generates all the income for the business, your salary must reflect your time, effort, expertise, and success. It should also be in line with what other professional writers are earning in compensation.

Why am I making such a big deal about this reasonable salary thing? Your tax bill depends on how you receive the income from the S Corporation, whether in wages or distributions.

Wages = earned income. Wages are subject to self-employment tax. You’ll pay a 15.3% FICA tax on your wages.

Distributions =  passive income. The distributions you receive as a shareholder are not subject to self-employment tax.

Obviously, the instinct here is to pay yourself zero wages and take all your income as a shareholder distribution. Big savings, right? Nope. The IRS is wise to this and insists that shareholder-employees who provide substantial service to the company must take a reasonable level of salary compensation.

So what is a reasonable salary? It varies depending on industry and your particular company’s profitability. According to the Bureau of Labor Statistics, the 2017 median pay for writers and authors was $61,820. That includes a wide swath of writing fields, from copywriters to screenwriters to freelance content creators. On the other end, the Authors Guild published a survey indicating full time writers made an average of $20,300 in 2018. If you’re considering setting up an S Corporation, sit down with your tax advisor to look at all the factors, including your expected income, to set a reasonable salary.

Let’s dive into an example.

Audrey’s Dilemma

Audrey has become the bestselling author of a children’s series based on her Paw Patrol fan fiction. She expects to earn $100,000 in net profit this year and is trying to decide how to organize her business.

Audrey knows her individual income tax rate will be 22%.

She does some research and determines $50,000 would be accepted as a reasonable salary.

 

Pre-TCJA World

First, let’s take a look at how Audrey’s business would be taxed as a Sole Proprietorship vs. an S Corporation in the olden days of 2017. This example lives in the pre-Tax Cuts and Jobs Act world and, as the law is written now, will also be how she is taxed when certain provisions of the Act lapse in 2026.

Income

Here’s how Audrey would receive her income under each entity:

Sole Proprietorship
S-Corp
Salary $50,000
Net Business Income $100,000 $50,000

 

Tax and Expenses

Here are the taxes and other costs she would incur under both entities:

 
Sole Proprietorship
S-Corp
Self Employment Tax $14,130 $7,065
Self Employment Deduction ($1,554) ($777)
Payroll Tax   $550
Income Tax $22,000 $22,000
Misc Expenses   $2,000
Total Tax / Misc Expenses
$34,576
$30,838

As a Sole Proprietor, the entire $100K is subject to self-employment and income taxes, but as an S Corporation only the $50,000 salary is subject to self employment. Audrey adds in the other expenses, such as payroll taxes and miscellaneous costs like outsourcing her payroll and paying for legal and tax advisors.

Result

Audrey sees that she’ll pay significantly more as a Sole Proprietor than she would as a Shareholder-Employee.

 

TCJA World

Things have changed since the TCJA was passed in late 2017. Audrey has to consider two new factors:

  • individual income tax rates are temporarily lowered, and
  • there’s a new temporary deduction for all pass-through entities (which includes both Sole Proprietorships and S Corporations.) 20% of qualified business income is excluded from income tax. Qualified business income does not, however, include the salary Audrey would take as an employee of the S Corporation. 

She runs the scenarios again with the same 22% tax rate, but including the 20% QBI deduction.

Income

The QBI deduction will reduce the income subject to income tax:

  Sole Proprietorship S-Corp
Salary   $50,000
Business Income $100,000 $50,000
20% QBI Deduction ($20,000) ($10,000)

Tax and Expenses

Here are the taxes and expenses for each entity now:

  Sole Proprietorship S-Corp
Self Employment Tax $14,130 $7,065
Self Employment Deduction ($1,554) ($777)
Payroll Tax   $550
Income Tax $17,600 $19,800
Misc Expenses   $2,000
Total Tax / Misc Expenses $30,176 $28,638

Audrey’s tax bill went down in both business types, but she’ll still pay slightly more as a Sole Proprietor. TCJA had no effect on her self employment tax bill, but the 20% QBI deduction reduced her tax base for income taxes. What Audrey must consider next is how the income would be taxed at the state level. So far she’s only been looking at federal taxes, but many states place additional income taxes on S Corporation earnings. 

Based on Audrey’s tax rate, salary, and state requirements, she realizes that she’d have to receive income of $110,000 or more for the S Corporation to begin providing tax savings.

Result

When she considers both her federal and state taxes, Audrey would pay approximately the same as either a Sole Proprietor or a Shareholder-Employee when her income is expected to be $100K.

 

Decision


Audrey decides to operate as a Sole Proprietorship for tax purposes, although she’s considering becoming an LLC due to potential Paw Patrol copyright infringement liability.

Let us know how that works out, Audrey.

S Corporation Wrap Up

This post should have given you a bit more insight into how a Shareholder-Employee S Corporation operates. It’s a more cumbersome business structure than a simple Sole Proprietorship, but can provide tax benefits at high income levels. The threshold for providing tax advantages used to be around $100K in net earnings. Since the tax bill was passed in 2017, that threshold has increased to the $115-120K mark, depending on your rates and salary. If you’re hitting these income levels and are seriously thinking about setting up an S Corporation, talk to your tax advisor well before the March 15th filing deadline.

Happy planning!

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting services. Presentation of the material does not create a tax-professional-client relationship. The material is provided on an “as is” basis and is accurate and true to the best of my knowledge, but no representation or warranties of any kind are given about the material, and there may be errors, inaccuracies or omissions.

Share This