Oblivious Investor

A reader writes in, asking:

“In your opinion as a CPA – is there a minimum annual revenue threshold where looking at S-Corp tax treatment for a single member LLC makes sense given all the reporting requirements?”

Unfortunately there’s no way to make a useful rule of thumb here.

The tax savings from S-corp taxation (relative to sole proprietor taxation) come from the fact that profit from the business is not subject to self-employment tax (i.e., Social Security and Medicare taxes). But before there can be any profit, the business is required to pay the owner a “reasonable” amount of compensation, which will be subject to Social Security and Medicare taxes.

And there are several downsides to S-corp taxation as well. For example:

• The business will have to pay unemployment insurance tax to your state based on the wages the business pays to you,
• You will likely have a lower contribution limit to your retirement plans (because it will be based on your wages, rather than being based on what would have been the full profit from the business if it were a sole proprietorship),
• You will likely have a smaller Social Security benefit in the future (again, because it will be based on your wages, rather than being based on what would have been the profit from the business if it were a sole proprietorship),
• You will have to file Form 1120S (for the business) and Schedule E (for yourself) rather than just Schedule C,
• Your business will have to register with your state and with the federal government as an employer (if it has not done so already) and must satisfy all the related periodic reporting and tax-payment requirements. (A payroll service provider is super helpful here.)

So S-corp taxation doesn’t really become advantageous until the business can pay you a “reasonable” amount of compensation and then still have enough profit left over for the tax savings on that profit to outweigh all of the negatives mentioned above.

But the tricky point is that what constitutes “reasonable” varies dramatically from one situation to another. For example, a freelance writer would usually be able to get away with a much lower level of compensation than a cardiologist. Even within a given line of work it can vary significantly. For example, a business owner who spends very little time actually working for the business (e.g., because they have another full-time job) will generally be able to get away with a lower level of compensation than somebody who works full-time for their business.

The following are a list of factors that the IRS (or applicable court) will consider, in addition to any other factors that may be relevant to the situation:

• Your qualifications;
• The nature, extent, and scope of your duties;
• Your background and experience;
• Your knowledge of the business;
• The size and complexity of the business;
• The amount of time you devote to the business;
• The economic conditions generally and locally;
• The character and amount of your responsibility in the business;
• Whether or not the compensation is pre-determined based on activities to be performed or not determined until the end of the tax year;
• Amounts paid to you in prior years;
• The salary policy of the business with regard to other employees; and
• The amounts paid by similarly sized businesses in the same area to equally qualified employees for similar services.

Also, state laws play a significant role in the decision as well. In some states the cost of unemployment insurance tax is very minor because the tax rate is low, the wage base is low, or both. In some states it will have a larger impact. And some states (e.g., Illinois) impose an income tax on the S-corporation itself.

In short, there are simply too many moving pieces for a dollar-amount rule of thumb to be useful. The decision of whether or not to elect S-corporation taxation for a business really must be done on a case-by-case basis.