Every year, business owners leave thousands of dollars on the table by not making the S-Corporation election at the right time. Others jump in too early and waste money on unnecessary administrative costs.
The S-Corp election can save significant self-employment taxes, but timing matters. Here's how to know when the switch makes sense for your business.
The Self-Employment Tax Problem
If you operate as a sole proprietor or single-member LLC, all your net profit is subject to self-employment tax at 15.3% (12.4% Social Security plus 2.9% Medicare). On $100,000 of profit, that's $15,300 before you even get to income tax.
An S-Corporation changes this equation.
How S-Corps Create Tax Savings
With an S-Corp election, you become an employee of your own business. You pay yourself a "reasonable salary" and take remaining profits as distributions.
Only the salary portion is subject to payroll taxes. Distributions are not.
Example:
- $100,000 in business profit
- $40,000 reasonable salary (subject to 15.3% payroll tax)
- $60,000 distribution (not subject to payroll tax)
- Savings: 15.3% x $60,000 = $9,180
The Income Threshold Question
When does the switch make sense? The answer depends on your net profit and the additional costs of S-Corp administration.
Most CPAs recommend converting when taxable income exceeds $50,000. At this level, self-employment tax burden typically exceeds $7,500, which usually outweighs administrative costs.
Businesses earning less than $40,000 in net profit rarely benefit enough to justify the added complexity.
Ohio and Kentucky business owners should also factor in state-specific considerations. California business owners often see benefits once profit exceeds $70,000 due to higher state taxes.
The Hidden Costs
S-Corp status adds administrative burden. Annual costs typically include:
- Payroll processing: $500-$1,500/year
- Additional accounting and bookkeeping: $500-$1,000/year
- Quarterly Form 941 filings
- Annual W-2 and W-3 preparation
- State compliance requirements (varies by state)
Total administrative costs usually run $1,000-$3,000 annually. Your tax savings need to exceed this amount to make the election worthwhile.
The Reasonable Salary Trap
The IRS watches S-Corp owners who try to minimize salary to maximize tax-free distributions.
Red flags that invite audit scrutiny:
- Paying yourself $20,000 while taking $80,000 in distributions
- Salary significantly below industry standards for your role
- Large disproportion between salary and distributions
The IRS has disallowed S-Corp elections entirely when owners abused the salary/distribution split. Pay yourself what you would pay someone else to do your job.
How to Make the Election
To elect S-Corp status, file IRS Form 2553. Key deadlines:
- New businesses: File within 75 days of formation
- Existing businesses: File by March 15 to have the election apply for the full tax year
- Late elections: The IRS may grant relief for late filings if you had reasonable cause
For LLCs, you don't need to change your legal structure. You simply elect to be taxed as an S-Corp while remaining an LLC under state law.
When to Wait
Don't rush into S-Corp status if:
- Your income fluctuates significantly year to year
- You're still building the business and reinvesting all profits
- You plan to take on investors soon (S-Corps have ownership restrictions)
- Your state imposes heavy S-Corp taxes
The Bottom Line
Run the numbers before making the switch. Calculate your expected self-employment tax savings, subtract the administrative costs, and make sure the net benefit justifies the added complexity.
For most service businesses earning $50,000 or more in consistent annual profit, the S-Corp election makes sense. Below that threshold, the juice usually isn't worth the squeeze.
