When to Make the Switch to S-Corp?

For many business owners, the decision to elect S corporation (S-corp) status versus remaining a disregarded entity (such as a single-member LLC taxed as a sole proprietorship) is a pivotal one. While both structures offer pass-through taxation, the differences in how income is taxed—and the resulting impact on your bottom line—can be significant. If you’re already eligible for S-corp status, understanding the trade-offs is essential to making the right choice for your business.

Taxation Differences: The Heart of the Matter

Let’s start with the basics. As a disregarded entity, all business income, deductions, and credits are reported directly on your personal tax return, typically on Schedule C. The entire net earnings from your business are subject to self-employment tax, which covers both the employer and employee portions of Social Security and Medicare taxes. For 2026, this rate is 15.3% on the first $184,500 of net earnings, with an additional 2.9% Medicare tax on amounts above that threshold.

By contrast, an S-corp is a pass-through entity, but with a crucial distinction: shareholders who work in the business must be paid a reasonable salary, which is subject to payroll taxes. Any remaining profits can be distributed as dividends, which are not subject to self-employment tax. This creates a potential tax advantage—if your business generates more income than what would be considered a reasonable salary, you can reduce your overall employment tax liability by splitting your income between salary and distributions.

The S-Corp Advantage: Employment Tax Savings

The primary reason business owners elect S-corp status is to save on self-employment taxes. Here’s how it works in practice:

1. Suppose your business earns $200,000 in net income.
2. As a disregarded entity, the entire $200,000 is subject to self-employment tax.
3. As an S-corp, you might pay yourself a reasonable salary of $100,000 (subject to payroll taxes), and the remaining $100,000 can be distributed as dividends, not subject to self-employment tax.

This structure can result in thousands of dollars in tax savings each year. However, the IRS requires that the salary paid to shareholder-employees be “reasonable” for the work performed, and this is an area of frequent scrutiny. Underpaying yourself to maximize distributions can trigger audits and penalties.

The Trade-Off: Qualified Business Income (QBI) Deduction

While the S-corp structure offers employment tax savings, it comes with a trade-off: the potential reduction of the Qualified Business Income (QBI) deduction under IRC § 199A. The QBI deduction allows owners of pass-through entities, including disregarded entities, to deduct up to 20% of their qualified business income on their personal tax returns.

Here’s the catch: for S-corp owners, only the portion of business income that is distributed as QBI-eligible profits (not as salary) qualifies for the deduction. The salary you pay yourself as an S-corp shareholder is not eligible for the QBI deduction. In contrast, as a disregarded entity, your entire net business income (subject to certain limitations) is eligible for the QBI deduction.

Let’s revisit the earlier example:

1. As a disregarded entity with $200,000 in net income, you could potentially claim a QBI deduction on the full amount (subject to wage and income limitations).
2. As an S-corp, if you pay yourself a $100,000 salary and take $100,000 as distributions, only the $100,000 in distributions is eligible for the QBI deduction.

This means that while you save on self-employment taxes with the S-corp, you may lose part of the QBI deduction, which could offset some of the tax savings.

Administrative Considerations

S-corp status comes with additional administrative requirements. You’ll need to process payroll, file quarterly payroll tax returns, and submit a separate corporate tax return (Form 1120-S). There are also requirements for maintaining corporate formalities, such as holding annual meetings and keeping minutes. These added complexities can increase your accounting and compliance costs.

When Does S-Corp Status Make Sense?

Electing S-corp status is generally most advantageous when:

• Your business generates enough profit that, after paying yourself a reasonable salary, there are significant additional earnings to distribute as dividends.
• The employment tax savings outweigh the potential reduction in the QBI deduction and the increased administrative burden.
• You are prepared to comply with payroll and corporate formalities.

If your business is not yet highly profitable, or if you prefer simplicity and lower compliance costs, remaining a disregarded entity may be preferable.

TL;DR

The decision to elect S-corp status is not one-size-fits-all. It requires a careful analysis of your business’s profitability, your willingness to handle additional administrative tasks, and the interplay between employment tax savings and the QBI deduction. Consulting with a tax professional can help you model the numbers and make the most tax-efficient choice for your unique situation

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