When an S-Corporation Might Not Make Sense

Read any tax blog or article about the best way for self employed relief vets or practice owners to save big money on taxes and you’ll inevitably come across information for S-Corporations.

S-Corporations are many times misunderstood as business entities, however an S-Corporation is simply an election on how an entity will be taxed. For example, a business entity would be a sole proprietorship, LLC, partnership, C-corporation, among others.

Pass through business entities, such as sole proprietorships and LLCs, default to being taxed as a sole proprietor, but the LLC can file form 2553 to elect to be taxed as an S-Corporation.

S-Corporations are often favored for their pass-through taxation benefits and potential savings on self-employment taxes. However, several situations might make choosing this structure less advantageous:

 

Low Profit Margins

If your business operates on thin profit margins, the cost of maintaining an S-Corporation structure might outweigh the tax benefits. S-Corporations come with additional administrative requirements and costs, including filing fees, accounting, and payroll services.

 

Administrative Burden and Costs

Maintaining an S-Corp involves extra paperwork and compliance measures. This includes regular board meetings, formal minutes, and other corporate formalities. These administrative tasks might require professional assistance, adding to the overall cost.

 

Self-Employment Tax Considerations

While S-Corporation owners can potentially reduce their self-employment tax burden by paying themselves a reasonable salary and taking the remaining income as distributions, the salary must be “reasonable.” If the IRS deems the salary unreasonably low, it could trigger audits and penalties.

 

Advantages of Being Taxed as a Sole Proprietor

In contrast, being taxed as a sole proprietorship can offer some advantages in specific scenarios:

 

Higher Social Security Benefit

Sole proprietors pay self-employment taxes (15.3% in 2023) on their entire net income. On the other hand, S-Corporation owners only pay self-employment taxes on their reasonable salary and any remaining distributions aren’t subject to these taxes which can help reduce overall tax liability. However, by paying less Social Security and Medicare tax, S-corporation owners can potentially reduce their Social Security benefit in the future by paying less into the program.

 

Increased Qualified Business Income Deduction (QBI)

Under the Tax Cuts and Jobs Act (TCJA), eligible businesses can claim a deduction of up to 20% of qualified business income. However, S-Corporations might limit this deduction due to the necessity of paying a reasonable salary, reducing the amount of income that qualifies for the deduction. Take a look at the example below of a business earning $100,000 in net business income:

Business Income: $100,000

Sole Proprietorship:

As a sole proprietor, you report your business income directly on Schedule C of your personal tax return. The entire $100,000 qualifies for the QBI deduction.

QBI Deduction Calculation:

20% of $100,000 = $20,000 deduction

Assuming a tax rate of 24% for simplicity:

Taxable Income after QBI Deduction = $100,000 – $20,000 = $80,000

Income Tax (at 24%) = $80,000 * 0.24 = $19,200

S-Corporation:

In an S-Corporation, let’s say you pay yourself a reasonable salary of $50,000 and take the remaining $50,000 as distributions.

QBI Deduction Calculation:

As the salary is considered reasonable compensation and isn’t part of QBI, only the $50,000 distribution qualifies for the QBI deduction.

20% of $50,000 = $10,000 deduction

Taxable Income from salary (after payroll taxes): $50,000

Taxable Income from distributions after QBI Deduction = $50,000 – $10,000 = $40,000

Total Taxable Income = Salary + Distributions = $50,000 + $40,000 = $90,000

Income Tax (at 24%) = $90,000 * 0.24 = $21,600

Comparison:

Sole Proprietorship:

Taxable Income after QBI Deduction = $80,000

Income Tax = $19,200

S-Corporation:

Taxable Income after QBI Deduction = $90,000

Income Tax = $21,600

 

In this scenario, the sole proprietorship benefits from a lower taxable income after the QBI deduction ($80,000 vs. $90,000 for the S-Corporation). Consequently, they pay $2,400 less income tax despite both entities generating the same $100,000 in business income.

This illustrates how sole proprietors can potentially benefit from the QBI deduction on their entire business profit, while S-Corporation owners may face limitations due to the requirement of paying themselves reasonable compensation and the subsequent restriction of QBI to only the remaining distributions.

 

Simplified Accounting and Tax Filing

Being taxed as a sole proprietor, your business income is reported on Schedule C of your personal tax return (Form 1040). This simplicity in reporting can reduce the need for costly CPA services and streamline tax filings.

 

Lower Overhead Costs

Entities taxed as sole proprietors generally face lower overhead costs compared to S-Corporations. Without the need for corporate formalities, maintaining an S-Corp structure can be more expensive due to additional legal and administrative requirements.

 

Conclusion

While S-Corporations offer potential tax advantages, they might not always align with the needs and financial circumstances of every business owner. Opting for a sole proprietorship can provide simplicity, lower overhead costs, and greater flexibility, especially for businesses with lower profit margins or those not requiring the extensive structure of an S-Corporation.

However, tax considerations are just one aspect of the decision-making process. Consulting with a knowledgeable tax advisor or financial planner to assess your specific situation is crucial in determining the most advantageous business structure for your needs.

 

Andrew Langdon is a CERTIFIED FINANCIAL PLANNER™, CERTIFIED Student Loan Professional™ and the founder of VetWorth, a fiduciary fee-only financial planning firm dedicated to serving the unique needs of veterinarians and their families.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.

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