When an S Corporation Election Makes Sense (and When It Doesn’t)

Every fall, a few business owners ask the same question: “Should I be an S corp?” The pitch they’ve heard is simple. Instead of paying self-employment tax on all of your profit, you pay yourself a salary, and the rest comes out as a distribution that isn’t subject to Social Security and Medicare tax.

That part is true. What the pitch leaves out is what it costs to get there, and in Tennessee some of those costs are bigger than people expect.

What changes when you elect

• You must pay yourself a reasonable salary through payroll, with withholding, quarterly payroll returns and a W-2.
• The business files its own federal return, Form 1120-S, by March 15 for a calendar year.
• If you were a sole proprietor, the business now typically needs to be an LLC or corporation, which means Tennessee franchise & excise tax applies.
• Health insurance and retirement contributions for owners are handled differently and need care.

The reasonable salary question

The IRS expects an owner who works in the business to be paid what the work is worth. A salary set unrealistically low to maximize distributions is the most common S corporation problem we see in IRS letters. We look at what you do, the hours you work and what similar roles pay locally, and we write down how we got there.

If the savings only work with a salary you couldn’t defend, they aren’t savings.

A rough way to think about break-even

An election rarely pays before your net profit is consistently well above a defensible salary for your role. Below that, the extra return, payroll costs and franchise & excise tax tend to eat the self-employment tax you save. Above it, the savings can be meaningful year after year.

Timing matters too. For an election to apply to a calendar year, Form 2553 is generally due within two months and 15 days of the start of the year, which is March 15. Late-election relief exists, but it’s better not to need it.

What we do in a planning meeting

We bring two side-by-side projections for next year: one as you are, one as an S corporation, with salary, payroll costs, both returns and Tennessee taxes included. If the difference doesn’t clearly justify the extra work, we say so.

This article is general information, not advice for your situation. Book a planning meeting before you make an election.