Tax Truths: Do S Corporations Always Provide Tax Savings?

S corporations are a popular type of entity structure for good reason. S-corps are pass-through entities which means federal tax is paid on profits at the individual rather than the corporate level. One of the most appealing aspects of owning an S-corp is the ability to take distributions that aren’t subject to payroll tax. Payroll taxes are 15.3% and cover Social Security as well as Medicare. The tax savings sound almost too good to be true and, unfortunately, there’s a catch. 

All S-corp owners are required to pay themselves a reasonable salary. This is because the IRS is wise to those who try to avoid payroll taxes by taking all their gross receipts as distributions instead. People who do this run the risk of having some of their distributions recategorized as salary. 

While you have discretion in determining what constitutes a reasonable salary for yourself, you need to make sure the amount you choose is in line with IRS rules. These rules aren’t explicit but, in general, a reasonable salary is the amount an equivalent business would pay for the same (or similar) services. Some factors to consider include your business earnings as well as experience, responsibilities, industry averages, and more. You’ll then have to pay payroll taxes on whatever amount you choose for your salary. 

The takeaway is that S-corps can provide significant tax savings, but they can’t help you escape them entirely. If you’re considering becoming an S-corp, it’s important to factor the cost of running payroll into your decision. This will help you determine whether it’s worth it from a tax-perspective since S-corp ownership comes with additional expenses related to compliance.