Should I File as an S Corp? Pros, Cons, and Tax Considerations  

Key Takeaways: 

• S corps can reduce self-employment taxes by allowing owners to take part of their income as distributions, which aren’t subject to payroll tax. 

• Eligibility is strict: 100 or fewer U.S.-based shareholders, one class of stock, and certain business types only. 

• Electing S corp status requires IRS Form 2553 within 75 days of formation or 2 months and 15 days into the tax year, plus setting up payroll. 

• Compliance is ongoing, including payroll filings, annual Form 1120-S, and proper reasonable salary documentation. 

• State taxes vary. Some states impose an additional S corp tax or franchise fee. 

• Best suited for profitable businesses earning at least $60K–$100K after expenses and comfortable handling (or outsourcing) added admin work. 

Deciding whether to file as an S corporation (S corp) can be a major choice for small business owners, freelancers, and entrepreneurs. The decision often comes down to weighing potential tax savings against the added complexity of compliance. While S corp status can help reduce self-employment taxes and boost your credibility, it also comes with strict rules, paperwork, and ongoing responsibilities. This guide will walk you through how S corps work, the pros and cons, tax implications, and situations where electing S corp status might (or might not) make sense. 

What Is an S Corp? 

An S corp is a tax classification recognized by the IRS. You can elect S corp status if your business is a domestic corporation or a limited liability company (LLC) that meets IRS eligibility requirements.  

When you elect to be taxed as an S corp, your business is treated as a pass-through entity, meaning profits and losses flow directly to your personal tax return. This avoids the double taxation that C corporations face, where income is taxed at both the corporate and shareholder levels. 

How S Corp Taxation Works 

An S corp has a unique tax setup compared to sole proprietorships and default-taxed LLCs.  

Owner-Employee Structure 

As an S corp owner, you wear two hats: you’re both a shareholder (owner) and an employee. You must: 

• Pay yourself a reasonable salary for the work you perform. 

• Withhold and remit payroll taxes (Social Security and Medicare) on that salary. 

Overall, any remaining profit can be distributed as dividends (owner’s draw) without being subject to payroll taxes. 

Pass-Through Taxation 

The S corp itself generally doesn’t pay federal income tax. Instead, profits and losses are reported on your personal tax return through Schedule K-1, and you pay income tax at your individual rate. 

Distributions and Self-Employment Taxes 

This is where S corps shine for many business owners: 

• Salary = subject to 15.3% self-employment tax (FICA taxes). 

• Distributions = not subject to self-employment tax. 

By strategically balancing salary and distributions, you can potentially lower your overall tax burden. 

For example, let’s say your LLC earns $120,000 in net profit. Without an S corp election, you’ll likely pay self-employment tax on the full $120,000. With S corp status, you could instead pay yourself a reasonable salary—say $70,000—subject to payroll taxes. You can then take the remaining $50,000 as a distribution, which isn’t subject to self-employment tax. This structure can save thousands in taxes annually.  

Potential Benefits of an S Corp 

Electing S corp status can deliver significant advantages if your business’s financial situation is right. 

Self-Employment Tax Savings 

The biggest draw is reducing self-employment taxes. For example: 

• Without S corp: $120,000 profit × 15.3% = $18,360 in self-employment tax. 

• With S corp: $70,000 salary × 15.3% = $10,710 in payroll tax (distributions are exempt). 

That’s a savings of $7,650 before even factoring in potential income tax benefits. 

Avoidance of Double Taxation 

Unlike a C corporation, an S corp avoids corporate-level income tax. Profits pass directly to your personal return, so you only pay once. 

Limited Liability Protection 

If your business is structured as an LLC or corporation, electing S corp status doesn’t change your liability shield. Your personal assets generally remain protected from business debts and legal claims. 

Enhanced Credibility 

Operating as an S corp can signal professionalism to clients, vendors, and lenders. It may help you appear more established compared to a sole proprietorship. 

Retirement Contribution Opportunities 

As an S corp owner-employee, you may qualify for a Solo 401(k) or SEP IRA. These plans can allow for higher contribution limits, especially when you pay yourself a reasonable salary. 

Potential Drawbacks of an S Corp 

You may be thinking to yourself, “This sounds great. Why doesn’t everyone have an S corp?” Basically, the benefits come with trade-offs that may not be worth it for every business. 

Increased Complexity and Costs 

S corps require: 

• Payroll processing (even for one owner). 

• Quarterly and annual payroll tax filings. 

• Corporate minutes and shareholder meetings. 

• More sophisticated bookkeeping. 

This often means higher accounting fees, sometimes hundreds or thousands more per year. 

IRS Scrutiny Over Reasonable Salary 

The IRS expects you to pay yourself a fair market wage based on your role and industry. Underpay yourself, and they may reclassify your distributions as wages, assess back taxes, and apply penalties. 

Ownership Restrictions 

S corps face several limits: 

• No more than 100 shareholders. 

• Shareholders must be U.S. citizens or residents. 

• Only one class of stock allowed. 

These rules can restrict fundraising and ownership structure flexibility. 

State-Level Taxes 

Not all states treat S corps the same. Some, like California, impose a state-level S corp tax or franchise fee (California’s is 1.5% of net income, with a $800 minimum). You may have to file separate state forms even if your S corp is recognized federally. 

When S Corp Status Might Make Sense 

S corp status often works best for established, profitable businesses. Here’s when it’s worth exploring: 

• You’re generating at least $60,000–$100,000 in annual profit after expenses. 

• You don’t need to reinvest all profits into the business. 

• You want to take advantage of tax savings on distributions. 

• You’re comfortable with, or willing to outsource, the extra compliance work. 

Let’s look at an example. Alex is a freelance web developer with $110,000 in net profit. As a sole proprietor, they’d pay self-employment tax on the full amount. As an S corp owner paying themselves an $80,000 salary and taking $30,000 in distributions, Alex saves over $4,500 in self-employment taxes, even after factoring in payroll service costs. 

When to Hold Off on S Corp Status 

There are cases where the costs and complexity outweigh the benefits. You may want to wait if: 

• Your profit is under $50,000–$60,000 annually. 

• You’re in your first year and income is unpredictable. 

• You plan to reinvest nearly all profits back into the business. 

• You don’t want to manage payroll or hire a bookkeeper. 

In these situations, staying as a default-taxed LLC or sole proprietor can be simpler and more cost-effective. 

How to Elect S Corp Status 

Electing S corp status is a two-step process: you first form an eligible entity, then formally elect the S corp tax classification with the IRS. While the forms themselves aren’t complicated, the timing and eligibility rules are critical. 

Step 1: Form an Eligible Business Entity 

You must first have a domestic corporation or an LLC registered with your state. Many small business owners choose to form an LLC because it’s flexible, relatively simple to maintain, and offers liability protection. However, a C corporation can also elect S corp status. If you’re already operating as a sole proprietorship, you’ll need to form an LLC or incorporate before you can make the election. 

Step 2: Check Eligibility Requirements 

Before filing, make sure you meet IRS rules: 

• Your business has 100 or fewer shareholders. 

• All shareholders are U.S. citizens or resident aliens (no foreign owners). 

• You only issue one class of stock. 

• Your business is not an ineligible type, such as certain financial institutions, insurance companies, or domestic international sales corporations. 

Failing to meet these requirements, even accidentally, can cause the IRS to revoke your S corp status. 

Step 3: File IRS Form 2553 

To officially elect S corp status, submit Form 2553, Election by a Small Business Corporation, to the IRS. This form must be signed by all shareholders and include details such as your business’s EIN, incorporation date, and tax year. 

Be sure to keep filing deadlines in mind: 

• If you want the S corp election to apply to the current tax year, file within 2 months and 15 days after the start of the tax year. 

• New businesses generally have 75 days from their formation date to file for S corp status effective in their first year. 

If you miss the deadline, you may be able to request late election relief by showing reasonable cause. 

Step 4: Set Up Payroll 

Since S corp owners who work in the business are considered employees, you must establish a payroll system to: 

• Pay yourself and any other employees. 

• File payroll tax returns (Forms 941, 940, and any state equivalents). 

For example, many S corp owners use payroll software like Gusto or QuickBooks Payroll to automate calculations, withholdings, and filings. 

Step 5: Update Your Books and Records 

Once you’re an S corp, your accounting becomes more structured. You’ll need: 

• A separate business bank account. 

• Accurate payroll records. 

• An accounting method (often accrual or cash) that supports your tax filings. 

This ensures you can document your reasonable salary, track distributions, and comply with IRS reporting requirements. 

Key Tax and Compliance Considerations 

Running an S corp comes with ongoing legal and tax responsibilities. These are not optional. Failure to follow them can result in penalties, interest, or even the loss of your S corp status. 

Federal Tax Filings 

• Form 1120-S: Annual informational return for S corporations. Reports the company’s income, deductions, and allocations to shareholders. 

• Schedule K-1: Issued to each shareholder, showing their share of income, losses, and distributions. Shareholders use this to report the income on their personal tax returns. 

Payroll Tax Filings 

• Form 941: Quarterly payroll tax return for federal income tax, Social Security, and Medicare withholdings. 

• Form 940: Annual federal unemployment (FUTA) tax return. 

• State payroll forms: Depending on your state, you may also have quarterly state income tax and unemployment filings. 

State-Level Requirements 

States vary widely in how they treat S corps. Some, like Texas, do not impose a state-level corporate income tax but may have franchise tax obligations. Others, like California, charge an annual 1.5% S corp tax (with a minimum $800 fee). Be sure to contact your state’s Department of Revenue to confirm your S corp’s obligations. 

Reasonable Salary Documentation 

The IRS pays close attention to the “reasonable salary” requirement. To protect yourself in an audit: 

• Reference Bureau of Labor Statistics wage data for your industry. 

• Document your role, responsibilities, and hours worked. 

• Keep payroll records showing timely payment and proper tax withholdings. 

For example, let’s say you run a marketing agency and work full-time as the primary strategist. The reasonable salary might align with industry averages for marketing managers in your area at $75,000. If the IRS sees you pay yourself $20,000, it’ll be clear to them that you are just trying to minimize taxes. 

Corporate Formalities 

Even if your state’s LLC laws are informal, acting like a corporation helps maintain your liability protection. This may include: 

• Holding annual shareholder meetings. 

• Recording meeting minutes. 

• Keeping your corporate records updated with any changes in ownership or structure. 

Separate Finances 

Co-mingling business and personal funds can pierce the corporate veil, exposing your personal assets in a lawsuit. Always use a dedicated business bank account and credit card for S corp transactions.  

Deadlines and Penalties 

Missing payroll filings, late tax payments, or ignoring state requirements can trigger costly penalties. Using an accountant or payroll service can help you stay compliant year-round. 

Making the Decision 

The decision to elect S corp status shouldn’t be made solely on the promise of tax savings. Factors to consider include: 

• Your current and projected profit levels. 

• How you plan to pay yourself (salary vs. distributions). 

• Your tolerance for administrative work or budget for outsourcing. 

• State-specific tax treatment that may reduce or eliminate savings. 

Speaking with a CPA or tax attorney can help you run the numbers and understand the long-term implications. 

Frequently Asked Questions 

Is it better to file as S corp or LLC? 

An LLC offers simplicity and flexibility, while an S corp election can save on self-employment taxes for profitable businesses. If your business earns consistent income above $60K–$100K and you’re comfortable with payroll and compliance, an S corp may be more tax-efficient. 

What are common S corp mistakes to avoid? 

Common mistakes include underpaying yourself, failing to maintain payroll records, missing IRS filing deadlines, co-mingling personal and business funds, and neglecting state-level compliance requirements. Avoiding these errors helps protect tax savings and liability protections. 

Why would you not want to be an S Corp? 

S corps add complexity, require payroll processing, and come with strict shareholder and stock restrictions. For new, low-profit, or reinvesting businesses, the administrative burden and costs can outweigh the tax benefits. 

How much should I pay myself from my S corp? 

You must pay yourself a “reasonable salary” based on your role, industry standards, and hours worked. The IRS expects this to reflect fair market value, with additional profits taken as distributions to reduce self-employment taxes. 

Am I considered self-employed if I own an S corp? 

As an S corp owner, you are technically an employee for salary purposes and pay payroll taxes on wages. Distributions are not considered self-employment income, though you still report profits on your personal tax return. 

What is the 60/40 rule for S corp? 

The 60/40 rule often applies to S corp owners deciding how to split income between a reasonable salary and distributions. Typically, the IRS expects a fair balance (around 60% salary and 40% distributions) though the exact ratio depends on industry standards, business profits, and the owner’s role. 

Tax Help for S-corps 

So, should you file as an S corp? The answer depends on your profits, your willingness to handle compliance, and your business goals. For the right business, S corp status can be a powerful tool to reduce self-employment taxes, protect your personal assets, and boost credibility. But for new or low-profit businesses, the complexity may outweigh the benefits. Take the time to evaluate your specific situation, run projections, and seek professional guidance before making the election. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.   

If You Need Tax Help, Contact Us Today for a Free Consultation