As I mentioned above, there is an interesting article about this, but I thought I’d add in a few more thoughts.  Many tax preparers love setting up S Corporations for their small business clients.  Their argument is that the taxpayer can save on their self-employment tax, which is an additional tax on sole proprietors.  So while S corporation owners only have to pay income tax on their earnings, sole proprietors have to pay two (income tax and self-employment tax).

Of course, the IRS counters this with the “reasonable compensation” argument.  So some of the S corporation earnings must paid to the owner(s) as salary and receive a Form W-2 from his or her own S Corporation.  And as salary, payroll taxes must be paid on it and so the tax savings from forming an S Corporation is reduced.

There are several other issues that need to be considered before deciding to form an S corporation:

  • Additional tax return.  Keep in mind that an S corporation has to file its own tax return separate from the owner.  That’s an additional tax preparation fee that can cost as much as preparing the owner’s personal tax return or more.
  • Payroll costs.  Putting the owner on payroll creates a lot more paperwork.  There are monthly, quarterly and annual payroll forms that need to be filed as well as payroll taxes that need to be paid.  This is an additional cost to the business owner.
  • Retirement benefits.  S corporation owners can contribute to their retirement plan based only on their salary income from the S corporation.  If you keep their salary small, you are limiting how much they can contribute to their own retirement.
  • Social security benefits.  By limiting the small business owner’s earned income (by having a small salary in comparison to the S corporation’s earnings), this can impact on the owner’s eventual social security benefits when he or she retires.