The S-corp election, revisited
A tax structure designed for a particular kind of business, pushed in 2016 at businesses it does not fit
Contents 4 sections
n S-corp is a tax election, not an entity. It sits on top of a corporation or an LLC and changes how the IRS treats the owners' pay. That is the whole of it, and the whole of what the strip-mall CPA circuit has turned into a $400 upsell this year.
The pitch is familiar to anyone who has walked into a tax office in a suburban Texas strip: the preparer looks at your Schedule C, points at the self-employment tax line, and says you are leaving money on the table. Sometimes that is true. More often, in 2016, it is not.
Who the form was built for
Subchapter S was written in 1958 for closely held domestic businesses whose owners wanted corporate liability treatment without the double-taxation of C-corp dividends. The eligibility rules still read that way. An S-corp may have no more than 100 shareholders. It may have only one class of stock, though differences in voting rights do not count as a second class. Every shareholder must be a U.S. citizen or resident alien; a single nonresident-alien shareholder breaks the election. Most trusts and estates are ineligible, with narrow exceptions for grantor trusts, QSSTs, ESBTs, and a few others. No entity shareholders, which means no LLC holding S-corp stock, no partnership holding S-corp stock, and no corporation holding S-corp stock except in the limited QSub case.
The point of the rules is to keep the form what Congress imagined: small, domestic, human-owned. Any time a client's situation bumps up against an edge — a non-citizen spouse with community-property rights, a family trust that was supposed to be a shareholder, a venture fund that wants to invest — the election is either impossible or fragile.
To elect, you file Form 2553, signed by every shareholder. For an existing entity, the election must be filed by the 15th day of the third month of the tax year you want it to take effect. For a new entity, the rule is 75 days from formation. The IRS grants late- election relief generously under Rev. Proc. 2013-30, but "generously" is not "automatically," and a botched 2553 is the kind of thing that eats six billable hours and a tax season.
The payroll-tax math, honestly
The sales pitch rests on one number. A sole proprietor reporting on Schedule C pays self-employment tax — 15.3% — on the first $118,500 of net earnings in 2016, then 2.9% Medicare on everything above, plus the 0.9% Additional Medicare Tax above $200,000 single or $250,000 joint. An S-corp shareholder-employee pays FICA only on the W-2 wage the corporation pays them. The remaining distributions pass through untouched by payroll tax.
Run the math on a sole proprietor clearing $120,000 net. If the S-corp pays a $60,000 reasonable wage and distributes $60,000, the FICA base drops by roughly $58,500. At 15.3%, that is about $8,900 of payroll tax saved, minus the employer-side FICA the S-corp now pays on the $60,000 wage — though that employer share is deductible at the entity level, which softens it. Call the net savings $6,000 to $7,500, depending on state.
Against that, subtract: a payroll service ($600 to $1,200 a year), a separate entity return (Form 1120-S, add $600 to $1,500 to your CPA bill), quarterly 941s and state withholding registrations, workers' compensation coverage in states that require it for owner-employees, and the cost of your own time administering the above. The break-even, in our experience, sits somewhere around $40,000 to $50,000 of consistent net income above what the owner would reasonably draw as wages. Below that, the election costs more than it saves.
The reasonable-compensation doctrine is the other half of the math and the half that CPAs discussing the election at the kitchen table tend to skip. The IRS does not tell you what reasonable is; it tells you, through cases like Watson and Glass Blocks Unlimited, that it will recharacterize distributions as wages when the wage is visibly too low. A single-shareholder S-corp where the owner does all the work and pays herself $18,000 in wages against $150,000 in distributions is the textbook audit target. A defensible wage looks like what you would pay someone else to do your job. If you cannot say that number without flinching, the election is not saving you as much as you think.
The traps nobody mentions at the sale
Health insurance paid by an S-corp for a more-than-2% shareholder is added back to W-2 wages as taxable compensation, though it remains deductible above the line. Every year, a share of S-corps forget this, file W-2s without the add-back, and produce an ugly amended return in March. The same 2% rule pulls in HSA contributions, group-term life above $50,000, and several fringe benefits a C-corp employee takes for granted.
Inadvertent termination is the other recurring failure. The election ends the moment the entity fails an eligibility rule, and the entity almost never notices in real time. A shareholder marries a nonresident alien and the community-property split quietly creates a disqualified shareholder. A shareholder dies and the estate holds the stock past the two-year grace period. A well-meaning founder issues a convertible note with economic terms that the IRS views as a second class of stock — the safe-harbor debt rules in the regulations are narrow, and profit-participation features will blow them up. Relief under §1362(f) is available, but it is a private-letter ruling, and the ruling fee alone runs into five figures.
And then the exit. A buyer who wants to acquire assets rather than stock will typically want a §338(h)(10) or §336(e) election, which reaches through the S-corp and treats the deal as an asset sale. This is survivable and common, but S-corps cannot do tax-free rollover equity cleanly, cannot accept a VC preferred round without killing the election, and cannot be owned by anything more exotic than a qualifying individual or trust. A founder who picks S-corp in year one and then raises priced equity in year three will spend real money unwinding the election into a C-corp, often in a rushed window while a term sheet is live.
The honest take
For a cash-flow sole proprietor — a consultant, a dental hygienist running her own practice, an independent contractor with a steady book and no plans to take on outside capital — the S-corp election at the right income level is a sound piece of tax planning. It saves real money, and the administrative load, once set up, is small.
For a growth-oriented startup with any prospect of raising priced equity, bringing on an entity investor, hiring a nonresident-alien co-founder, or being acquired in stock, the S-corp election is a mistake. The CPA recommending it is optimizing for this year's tax return and not for the five-year arc of the business. Forming as a C-corp or an LLC that stays a partnership is worth the incremental tax.
The useful rule for 2016: if the business is the owner's job, the election is probably worth looking at above $50,000 of net income. If the business is trying to become something larger than the owner's job, leave the election alone.