What’s The Big Deal With S-Corps?

Summary/TL;DR

Distributions from S-Corporations are exempt from self-employment tax as a long as a “fair wage” is paid as a salary. Within certain ranges of taxable income, this positive impact of an S-Corp election could be outweighed by its negative impact on the Qualified Business Income Deduction. Above certain ranges of income, this is reversed and an S-Corp is the only way to reclaim QBID. There are additional things required of S-Corp shareholders that should also be taken into consideration in addition to their taxation characteristics. At the end of the day, the decision to switch to an S-Corp is not one that should be made absent the advice of a qualified tax/legal professional.

Introduction

Business owners are inundated with, let’s call it propaganda, about the seemingly magical S-Corp. And while it’s true that S-Corps can offer some truly outstanding tax benefits in many circumstances, their merits are often oversold, or their disadvantages are overlooked. Today’s post attempts to take a truly unbiased view of S-Corporations, including their advantages and disadvantages.

Please keep in mind when reading today’s post that I am not a tax or legal professional. No part of this post should be considered a recommendation or endorsement of S-Corps, and the examples I give below are overly simplified (and likely slightly inaccurate) for the purposes of illustrating “big picture” concepts.

S-Corps and Self-Employment Taxes

S-Corps are best known for the fact that they make above-basis distributions to shareholders tax-free. Like a partnership, all profits flow through to each individual shareholder’s personal tax return, regardless of whether or not the actual cash is taken from the business. Unlike a partnership, however, these flow-through profits are not subject to self-employment tax as long as a “fair wage” is paid to the shareholder on a W2 basis. What constitutes a “fair wage” is a grey area which is best left to your tax professional to determine.

When the facts presented above are taken into consideration, some clear tax-planning opportunities present themselves. For example, suppose your only income was from a partnership (in which you are the sole owner) that passed-through $250,000 in profit to you annually. You’re married and you and your partner file taxes jointly. Your tax return would look something like this for the 2024 tax year:

If, however, you were an S-Corp and paid yourself a salary of $100,000 for the year (upon recommendation by your CPA), then your tax return would look more like this:

Because you didn’t have to pay self-employment tax on your pass-through income, you saved about $9,000 in taxes for the year. While this is a highly oversimplified example, it effectively illustrates the primary tax-advantage of an S-Corp.

You might also notice a large decrease in your deductions, which totaled $70,600 in the Partnership example and only $56,905 in with the S-Corp. This is because the $100,000 salary that you paid yourself is not included in Qualified Business Income, which is what the Qualified Business Income Deduction (QBID) is based on. How S-Corp status affects QBID is where we will turn to next.

S-Corps and the Qualified Business Income Deduction

The impact that being an S-Corp can have on QBID is often overlooked, as QBID was only introduced in 2017 for small business owners, and is currently scheduled to sunset in 2026. Within certain income ranges, the negative impact that being an S-Corp can have on QBID will “crowd out” its positive impacts on self-employment tax. In these instances, you will likely end up paying more in taxes as an S-Corp.

As is typical for the US tax code, there are also exceptions to the above. In cases where taxable income exceed certain thresholds ($207,500 for single taxpayers and $415,000 for married), an S-Corp election could end up making your QBID higher than it otherwise would be. Beyond these thresholds, the calculation for QBID changes and is, generally, limited to 50% of the W2 wages paid out of the business. Using the same circumstances as the example above, this would be what a partnership tax return would look like with $600,000 in pass-through income (ignoring the Additional Medicare Tax – whose effect would be negligible for the purposes of this example).

If you instead filed as an S-Corp and paid yourself a salary of $164,248, your tax return would look like this (again, ignoring the Additional Medicare Tax):

In this case, the decision to change to an S-Corp was not trivial as it saved almost $45,000 in tax. Whether or not a $164,248 salary would be a “fair wage” is between you and your CPA, but the spirit of this example remains the same: S-Corps can be very powerful when you are within or above the income phaseouts for QBID.

S-Corps Are Not For Everyone

Unfortunately, S-Corps are often portrayed as a magic pill that will cure everyone’s tax headaches with no strings attached. The truth, as we’ve seen, is more nuanced. Many could end up paying more in taxes as an S-Corp due to the effect that taking a salary has on the QBID among other things. S-Corps also disallow shareholders from taking disproportionate distributions, unlike partnerships which offer more flexibility. Paying yourself a salary will also affect retirement plan contribution limits, which is not usually something that you have to worry about as a partnership. At the end of the day, you should never make a decision as substantial as an entity election without the guidance of a tax and/or legal professional.