S Corporations for an operating business have become the “go-to” advice. Especially with service businesses.

A lot of tax professionals give this advice without considering all the relevant factors. Whenever a business owner is making any money at all, the S Corporation becomes the top choice.

I know this is true from experience. Over 95% of my current clients and prospects come to me either with an S Corporation already or asking about one.

I have also seen other business coaches and consultants give blanket advice here. Most of them are not qualified to be making those recommendations. And they can end up costing their clients money.

Using an S Corporation in your tax strategy depends on many factors. The stage your business is in, how much taxable income (not just top-line revenue) your business generates, ownership of your practice (current and future). It also depends on the other income on your personal tax return. Your S Corporation income will flow through to your personal return. So what happens there matters.

Entity selection is one of the most important pieces of a comprehensive tax strategy. It’s not the only piece, but the choice here will impact the rest of your tax strategy. Using the entities properly is even more important.

How The S Corporation Saves You Employment Taxes

After analyzing thousands of tax returns over the past 16 years, here’s the thing to remember. There is ONE core tax benefit an S Corporation gives you.

The one tax benefit of an S Corporation is it helps you limit your self-employment tax. Which, for purposes of this article, is the same as your payroll taxes, or FICA. It’s the same tax, called different names depending on where it’s assessed.

That’s it. There’s no other tax reason to be an S Corporation.

Take a look at the image below showing the Employment Tax Comparison. I built this hypothetical scenario using a business with taxable income of $80,000 after all expenses. 

The magic happens when the S Corporation sets a reasonable compensation for the owner. In this example, that salary is $40,000. Only that salary is subject to the 15.3% FICA payroll tax. The remaining $40,000 net income is not subject to FICA or self-employment tax.  The sole proprietor pays 15.3% on all $80,000 in taxable income.

Let that sink in. Same exact business, different entity structure. They didn’t have to spend any more money to create more deductions. It’s a more effective use of the tax code.

There are other tax savings opportunities with an S Corporation. But you can use all those strategies in any other business entity too. In fact, most of those tax strategies work better outside of an S Corporation than in one.

If you want proof of this, Google “more than 2% shareholder fringe benefits”. Today, there are 325,000 search results. Start reading about all the benefits you don’t get as the owner. (Be sure to come back and finish reading this too!)

2018 Tax Law Changes

Before 2018, the relevant factors here were easier to analyze. Especially if your business was your sole source or major source of personal income.  I could do the initial math in my head. Then confirm those calculations while developing the full tax strategy.

Since 2018, the Tax Cuts and Jobs Act added the Qualified Business Income Deduction. You may have heard of it referenced as the 20% pass-through deduction. In some cases, the math is still simple. But once you start becoming a high-earner (after considering ALL sources of income), things get more complex.

Editor’s note: As of the publication of this article, the 20% pass-through deduction is still set to expire after 2025. An act of Congress is required to keep it.

Now that we have the background info, let’s get into some problem areas.

Problem 1: Making The S Corp Election Too Soon

Most companies start out as an LLC (or PLLC). They are taxed as a sole proprietorship (single-member LLC’s) or a partnership (multi-member LLC’s). That is, unless they make an election to be taxed as a corporation.

One way to restate the core benefit of an S Corporation is that it shelters some of your taxable income from self-employment tax.

Be sure you have taxable income to shelter before you decide this is the right move.

It would be nice if we had a bright-line test to know when to make this election. That doesn't exist, unfortunately.

For an optometry practice owner, I generally start giving it more attention when the P&L bottom line is over $75k. But there are even exceptions to this.

Problem 2: Not Calculating Reasonable Compensation

Most S Corp owners shoot themselves in the foot on this strategy. It’s not intentional, they just got bad advice.

Most advisors do not go through the work of justifying the lowest possible salary that will pass IRS scrutiny. If your S Corp salary is too high, or over the social security wage base ($168,600 for 2024), you’ve lost most of the one benefit this entity provides.

The higher you set your salary, the less income you have available for the Qualified Business Income Deduction (QBID). That’s the 20% pass-through deduction I mentioned earlier.

This becomes a bit of a balancing act. Your salary should be high enough for the work you are actually doing in the practice. But low enough to maximize your QBID and FICA tax savings.

Reasonable compensation is not a “set it and forget it” calculation either. This is an active strategy that needs to be managed every year.

Problem 3: Outearning Your S Corporation

You outearn your S Corporation when your pass-through income (aka K-1 income) exceeds your personal compensation needs. You are generally starting to keep more earnings in your practice for future growth and expansion.

Once this pass-through income gets high enough, it will start to wreak havoc on your personal return. It will throw you into the highest tax brackets. Other tax benefits, like QBID, will start to phase out or get eliminated.

The solution to this is an advanced tax strategy. The common denominator with advanced tax strategies is you need excess cash flow that you can position for tax efficiency.

There are a lot of advanced tax strategies we could list. Which ones you use will depend on your personal financial and investment goals. Here are a few items so you get what I’m talking about:

• Multi-Entity Planning - commonly done with C Corporations to shift income away from your personal tax return

• Qualified Retirement Plans above and beyond the $23,000 (in 2024) you can contribute to a 401k

• Alternative Investments like real estate, syndications, and limited partnerships just to name a few.

• Other operating businesses

The absolute best thing to do is have a Comprehensive Tax Strategy developed for you. It’s the only way to take into account all the other variables and nuances I can’t go into here.

Take some time and reflect on these questions as we don't learn from our experiences alone, we learn from reflecting on our experiences. 

DISCLAIMER: The financial figures presented in this blog are for illustrative purposes only and should not be construed as financial advice. Actual results may vary depending on individual circumstances and market conditions. Readers are encouraged to consult with a qualified financial advisor or accountant before making any financial decisions based on the information provided in this blog.