5 Reasons Why You Should Consider an S Corporation

Why You Should Consider an S Corporation?

The introduction of the Tax Cuts and Jobs Act (TCJA) in 2017, which took effect in 2018, brought several compelling reasons to think about forming an S corp. Here are four key advantages:

1. Limited Personal Liability: One of the primary benefits is that shareholders and officers of an S Corp are not personally responsible for the corporation’s debts and liabilities. This legal separation can be crucial for protecting personal assets.

2. Tax Advantages: An S corp’s net income is not subject to self-employment tax, which typically includes Social Security and Medicare taxes (commonly known as FICA). This can result in significant tax savings, particularly for businesses with substantial profits.

3. Maximizing Deductions: The interplay between maximizing the 199A pass-through deduction and the savings on FICA taxes is another reason to consider an S corp. This unique combination of benefits is available only through an S corporation structure.

4. Strategic Financial Planning: Many new business owners might underestimate or misunderstand the benefits of an S corp. However, with proper guidance and strategic planning, the S Corp can be a powerful tool in building and protecting your business wealth.

Why Most Small Businesses Should Consider Operating as an S Corporation

The advantages of operating as an S corporation are significant, and for many small businesses, this structure can be a game-changer. The benefits of asset protection, tax savings, and overall financial efficiency cannot be overstated. In my view, the vast majority of small businesses with ongoing operations would greatly benefit from transitioning to an S corp.

Many entrepreneurs are already capitalizing on the savings that an S Corp offers, particularly in relation to self-employment taxes. However, it’s worth noting that some tax advisors may caution against this strategy. Their concern lies in the potential misuse of the S Corp structure to avoid taxes, which can draw scrutiny from legislators and regulators. While this is a valid point, it’s important not to dismiss the S Corp option without carefully considering how it could serve your business’s unique needs.

(A) Asset Protection Benefits of an S Corporation

Just like LLCs and corporations, one of the significant advantages of an S corporation is the asset protection it offers. The corporate veil—a legal barrier that protects your personal assets from business liabilities—applies to C corporations, S corporations, and LLCs alike, as long as the entity is properly established and maintained. Ensuring your S corporation is set up correctly is crucial to preserving this protection, which I discuss in more detail in Chapter 8.

(B) Savings on Self-Employment Taxes

One of the most appealing benefits of operating as an S corporation is the potential for significant savings on self-employment (SE) tax. If you run your business as a sole proprietorship or an LLC and generate ordinary income from sales or services, all of your net income is subject to SE tax.

For example, as outlined in the section on Sole Proprietorships (Chapter 2), in 2019, the full 15.3% SE tax applied to the first $132,900 of net income. This tax includes a 12.4% Social Security tax and a 2.9% Medicare tax. Beyond the $132,900 threshold, the 2.9% Medicare tax continues to apply, and for those earning more than $250,000 (for married couples filing jointly) or $200,000 (for single filers), the Medicare tax rate increases to 3.8%. This additional tax burden can quickly add up, significantly impacting your bottom line.

However, when you operate as an S corporation, this SE tax does not apply to the net profits of the business in the same way it does for sole proprietors or LLCs. This can result in substantial tax savings, making the S corporation a highly efficient structure for many small business owners.

As long as the S Corp owners draw a reasonable salary through payroll, reported via a W-2, the tax laws allow for a significant portion of their business profits to be classified as net income under a K-1. This approach can lead to substantial savings on self-employment (SE) tax.

The beauty of this strategy lies in its simplicity and effectiveness: as an S Corp owner, you only pay SE tax on the portion of your income that is considered payroll. The remaining income, which flows through to you as net profit or K-1 income, is not subject to SE tax. This not only reduces your overall tax burden but also allows you to keep more of your hard-earned money.

(C) Using the 199A Pass-Through Deduction

The 2018 tax law changes brought about a significant benefit for small business owners—the 199A deduction. This provision allows pass-through entities, such as S corporations, to claim a 20% deduction on their net profits, directly reducing their taxable income.

While this deduction is available to LLCs and sole proprietorships as well, it proves to be even more advantageous when paired with an S corporation structure. The reason is twofold: not only does an S Corp help you save on self-employment taxes, but it also allows you to maximize the benefits of the 199A pass-through deduction. This combination can lead to substantial tax savings, making the S corporation an attractive option for many small business owners.

(D) Building Business Credit

One of the additional benefits of establishing an S corporation is the opportunity to build business credit, often referred to as “corporate credit.” Many small-business owners choose to form an S Corp specifically for this reason. Once your S Corp is created, you’ll receive a Tax ID number, which allows you to begin the process of establishing credit in your company’s name. Although building business credit takes time, when done correctly, it can become a significant asset for your business. This ability to borrow funds under the company’s name is an important advantage that comes with operating as an S corporation. For more insights into building both personal and corporate credit, Chapter 7 provides a comprehensive guide.

(E) Avoiding the Affordable Care Act Tax

Many taxpayers may not be aware or might have forgotten that the Affordable Care Act (ACA) imposes an additional 0.9% tax on net income exceeding $200,000 for single filers and $250,000 for married couples filing jointly. This tax applies to any ordinary net income generated through a sole proprietorship or an LLC.

One of the distinct advantages of operating as an S corporation is the ability to avoid this additional ACA tax on certain income. Specifically, this 0.9% tax does not apply to the net flow-through income reported on a K-1 from an S corp. Instead, it only affects the income you receive as a salary through a W-2, and only if your total earnings exceed the $200,000/$250,000 thresholds. This provides a strategic benefit for S Corp owners looking to minimize their tax liability under the ACA.

While the benefits of an S corporation are substantial, they also come with responsibilities. A common pitfall for some small-business owners is the misuse of the S Corp structure, particularly when it comes to paying themselves an unreasonably low salary or no salary at all. This practice can jeopardize the integrity of the tax strategy and may attract unwanted scrutiny from the IRS.

When used correctly, the S Corp structure is a powerful tool for small business owners. Legislators recognize its value, and the self-employment tax savings strategy associated with S corps has been in place for many years. The Tax Cuts and Jobs Act (TCJA) has only further validated and expanded these benefits, making the S Corp an even more attractive option. I believe this strategy will remain valuable for years to come.