At some point, every growing freelancer and small business owner hears it from a friend, a podcast, or a stranger at a networking event: "You should really be an S corp." Sometimes that's good advice. Sometimes the extra payroll, paperwork, and state costs eat most of the benefit. Here's how to think it through before you decide.
How you're taxed today
As a sole proprietor or single-member LLC, your business profit flows onto your personal return. You pay income tax on that profit, plus self-employment tax of 15.3% on most of your net earnings, up to the Social Security wage base. Self-employment tax funds Social Security and Medicare, and it's the part an S corporation can change.
What changes with an S corporation
With an S corporation, you become an employee of your own company. You pay yourself a salary through payroll, and payroll taxes apply to that salary. Profit above your salary can be taken as distributions, which aren't subject to self-employment or payroll tax. Income tax still applies to all of it.
The catch: a reasonable salary
The IRS expects your salary to reflect what you would pay someone else to do your job. Setting it artificially low to avoid payroll tax is one of the most common reasons S corporations draw scrutiny. Your salary should be documented and defensible, and it should change as your role and the business change.
The costs that come with it
- Payroll. You'll run payroll for yourself, with quarterly filings and a year-end W-2.
- A separate business return. S corporations file Form 1120-S, due March 15 for calendar-year companies.
- State costs. In California, S corporations pay a 1.5% tax on net income, with an $800 minimum each year. LLCs taxed as S corporations may also owe the LLC fee.
- Cleaner books. Business and personal spending need to be fully separate, all year.
- A smaller QBI deduction. The salary you pay yourself doesn't count toward the qualified business income deduction, so that deduction can shrink.
When it tends to make sense
There's no single income number where an S corporation always comes out ahead. It's usually worth a closer look when:
- Your profit is steady, not a one-time spike.
- Your profit is comfortably above what a reasonable salary for your role would be.
- You're ready to run payroll and keep clean books every month.
If your profit is modest or swings widely from year to year, staying a sole proprietor is often simpler, and sometimes cheaper.
Timing matters
To be treated as an S corporation for a tax year, you generally need to file Form 2553 with the IRS within 2 months and 15 days after the start of that year. Missing the window can push the change to the following year, although the IRS does allow late elections in some situations.
Run the numbers first
The right answer depends on your profit, your state, and your plans. The only way to know is a side-by-side comparison of your total taxes and costs under each structure, using your real numbers.
We'd wait until profit had been steady for at least a full year before switching, and we'd compare the two structures using real numbers, including California's costs, not a rule of thumb. If the difference turned out to be small, we'd stay simple and look again next year.