Often, prospective clients meet with us excited to talk about their new S Corporation. When we start talking, though, it quickly becomes apparent that they won’t save nearly as much as they hoped. That leads to a discussion of how to move forward. With more forethought, you can avoid an unnecessary or costly election, or you can confirm that using an S Corp is a great cost-saving measure for you.
Why Use an S Corp?
An S Corp is typically seen as a way to save taxes. Colleagues and CPA firms say it’s an obvious choice, but there are more details to the decision. If you’re a 1099 worker or own your own business, you have two options to become an S Corporation. You can either establish a limited liability company (LLC) or a corporation. Then, by filing Form 2553 with the IRS, you elect to be an S Corp. When setting up that initial entity, you need to review state laws with your attorney. Some states, such as California, restrict you from practicing under an LLC.
Once you have completed your S Corp election, the business income, losses, deductions, and credits flow through to the owners of the business for federal tax purposes. When compared to a traditional C Corporation, this prevents double taxation on corporate income and related dividend income. More often, the comparison is between operating as an S Corp or reporting your business income on Schedule C of your individual return—either as a sole proprietor or a single-member LLC.
More information here:Is an S Corp Right for You?
Before taking those steps to establish an entity, you should complete a break-even analysis. Basically, the goal of electing S Corp status is to save on payroll taxes. As a high-income professional, this is Medicare tax savings, which is 2.9% of salary. While other professions might benefit from the higher percentage savings on Social Security tax, reasonable compensation for a physician is typically higher than the annual Social Security wage base.
Reasonable compensation is one of the key terms when operating as an S Corp. The IRS describes this as “value that would ordinarily be paid for like services by like enterprises under like circumstances.” For a physician, you look at factors surrounding your specialty, locale, and experience to determine a rate. If the IRS finds that the salary you pay yourself is unreasonably low, it can reclassify amounts of distributions and collect unpaid payroll taxes with penalty and interest. In an S Corp setting, the IRS is less likely to review and reclassify an unreasonably high salary.
Your analysis should always compare those Medicare tax savings on your “reasonable compensation” to the administrative costs of operating the S Corp. When electing as an S Corp, you need several ongoing services. You’ll either hire a CPA firm to handle them all or piece together solutions with yourself taking a more active role. One new service you will need is filing a business tax return. Form 1120S is due annually on March 15. This will provide Form K-1. It shows the income that passes through to you as the owner, and it is used for the preparation of your personal 1040 income tax return. Most S Corp owners choose to outsource this to a CPA firm.
You will now be an employee of your business (the S Corp), and you will need to process your payroll periodically. You will also have related payroll tax payments and filings to make. While you could do this all by hand, service providers include Gusto, ADP, or QuickBooks. You may also bundle this with your CPA firm’s services.
As an S Corp, you will have more bookkeeping records to maintain. As a sole proprietor, you may have totaled your receipts at year-end for your income tax deductions. Now, you will track everything that goes through your business accounts, so that you can accurately report your financials with your income tax return. This bookkeeping can be done by a CPA or bookkeeping firm, or you can do it yourself in bookkeeping software. Some options are QuickBooks, Wave, or Xero.
After you’ve determined how you want to handle these services, you can total the new fees to compare them to the Medicare savings. If you choose to handle any of these services yourself, be sure to account for the value of your time to complete the tasks.
Then, you should review some lesser-known items. These items can swing the needle in an obvious direction more so than the break-even analysis of Medicare tax savings vs. admin costs. Here are some of those items.
Other W-2 Earnings
Business income or 1099 income runs through your S Corporation. It matters how much you will earn annually, but it especially matters whether you have other W-2 earnings. Due to the way self-employment tax for Schedule C income vs. payroll taxes for an S Corp is calculated, you can end up double-paying Social Security taxes by over $11,000 in 2026 if you set up an S Corp when you also have W-2 earnings from another employer. You receive a refund of the employee side tax, but the employer side (YOU!) is never recouped. This makes an S Corp a costly mistake when you have other W-2 income.
State S Corp Taxes
While most states don’t impose a mandatory tax on S Corporations, a few do. Tennessee has an excise tax of 6.5%. California has a 1.5% tax with an $800 annual minimum. Operating an S Corp in Tennessee is too expensive to consider, and the additional California tax needs to be considered with all of the other costs. Other states have annual filing fees and local taxes you should consider.
Other Tax Implications
In addition to reviewing how much you will earn within the S Corporation, you also should look at a few factors from your overall tax picture. For example, if your taxable income is low enough to benefit from the Qualified Business Income (QBI) deduction, electing S Corp will cost you some of that deduction. QBI, or Section 199A, allows up to 20% of your net business income to be deductible and free from income tax. There are income limitations to this for specified service trades or businesses, like physicians. When you elect to be an S Corp, only the business profits, not the wages you pay yourself, qualify for this deduction. This consideration is most common for married physicians whose spouse doesn’t have earned income.
Pass-through entity taxes have made an interesting web of rules across the US at the state level. You should also review the impact of these taxes under the lens of your entire tax situation. If you can fully deduct your state and local taxes as itemized deductions with the higher SALT cap, you shouldn’t account for the resulting federal taxes saved by having your business pay these taxes. On the other hand, if your overall personal income is enough that you are limited to the $10,000 SALT cap, this extra deduction could be a benefit of operating as an S Corp.
Consistency of Earnings Source
While everyone’s crystal ball is cloudy, this strategy works best when it lasts for multiple years. If you plan to have similar 1099 earnings for years to come, it makes more sense to invest in setting up an S Corp. If you are unsure of how long you will keep these earnings or the earnings level, it may not be worth the complexity to set everything up only for a few months or a year of savings.
More information here:The Bottom Line
It is easy to believe you are missing out by not having a formal business entity, but often, operating as a sole proprietorship is the simpler and more cost-effective option than establishing an S Corp. The same business deductions and retirement plans are available whether you are a sole proprietor or an S Corporation. It’s important to think about your specific situation and decide if it’s truly worth it for you before electing S Corp status.
What do you think? If you elected to become an S Corp, what were the considerations that made your decision the right one? What else should people know about this decision?
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