To S Corp or Not to S Corp? A Guide for Texas Business Owners

As a business owner in Texas, one crucial decision you need to make is whether to designate your business as an S Corporation (S Corp) or not.

This choice can have significant implications for your business’s tax structure and overall financial strategy. In this blog post, we will explore the benefits and considerations of becoming an S Corp, including tax strategies and the potential advantages of hiring yourself as an employee. By understanding these factors, you’ll be better equipped to make an informed decision that aligns with your business goals.

Common Misconception: The most common misconception about S-Corps is that they are an entity type. They are not a type of entity. S Corp status is a taxable designation. Different entities, such as LLCs, partnerships, and regular incorporations, can designate themselves as S Corps, so long as they meet the IRS requirements.

What is an S Corporation?  S corporations are entities that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on their corporate income. S corporations are responsible for taxing certain built-in gains and passive income at the entity level.

Benefits of Designating as an S Corp:

1. Pass-through taxation: One of the primary advantages of an S Corp is its pass-through taxation feature. Profits and losses “pass through” the business to the shareholders’ personal tax returns, avoiding corporate-level taxation. This can result in significant tax savings, especially if your business generates substantial profits.
2. Self-employment tax savings: S Corp owners who work for the business can divide their income into two components: salary and distributions. Only the salary component is subject to self-employment taxes (Social Security and Medicare), while distributions are exempt. By structuring your income in this way, you can potentially reduce your self-employment tax liability.

Tax Strategies for S Corps:

1. Reasonable salary determination: When you hire yourself as an employee in an S Corp, you must establish a reasonable salary. The IRS requires you to pay yourself a fair wage for the services you provide, similar to what you would pay an unrelated employee in a comparable role. Paying yourself an unreasonably low salary to minimize self-employment taxes can raise red flags and lead to IRS scrutiny. Consulting with a tax professional can help ensure your salary determination complies with IRS guidelines.
2. Tax-deductible employee benefits: As an S Corp, you have the ability to provide tax-deductible benefits to yourself and your employees. These benefits can include health insurance, retirement plans (such as a 401(k)), and other qualified employee fringe benefits. Taking advantage of these deductions can reduce your taxable income while simultaneously attracting and retaining quality employees.

Example of Taxation of Sole Proprietorship: 

Suppose you own a Texas-based consulting business that generates an annual profit of $200,000. For simplicity, let’s assume you’re the sole owner and actively involved in the business. Here’s a comparison of tax scenarios between operating as a sole proprietorship and as an S Corporation:

1. Regular Taxation of a Sole Proprietorship: As a sole proprietor, all the business income is subject to both income tax and self-employment tax. Using a self-employment tax rate of 15.3% (12.4% for Social Security and 2.9% for Medicare) on the first $142,800 of net self-employment income (2021 rates):

Calculation:

• Net Business Income: $200,000
• Self-Employment Tax (15.3% of $200,000): $30,600
• Income Tax (assuming a 24% tax bracket): $48,000 (approximate federal income tax)
• Total Tax Liability: $78,600

2. Taxation as an S Corporation: As an S Corporation owner, you can split your income into a reasonable salary and distributions. Let’s assume a reasonable salary for your consulting services is $100,000, leaving $100,000 in profit distributions.

Calculation:

• Salary (subject to self-employment tax):
  • Self-Employment Tax (15.3% of $100,000): $15,300
  • Income Tax (assuming a 24% tax bracket): $24,000 (approximate federal income tax on salary)
• Distributions (exempt from self-employment tax):
  • Income Tax (assuming a 24% tax bracket): $24,000 (approximate federal income tax on distributions)
• Total Tax Liability: $63,300

In this example, by operating as an S Corporation and splitting your income into a reasonable salary and distributions, you could potentially save approximately $15,300 in self-employment taxes compared to operating as a sole proprietorship. Additionally, you may benefit from the tax savings associated with deductible business expenses, employee benefits, and other tax planning strategies available to S Corps.

It’s important to note that individual tax circumstances can vary, and this example is provided for illustrative purposes only. Consult with a qualified tax professional or attorney to evaluate your specific situation and determine the potential tax savings and benefits of choosing an S Corporation structure for your business. Disclaimer: The tax rates and regulations mentioned in this example are based on 2021. It’s essential to consider any updates or changes in tax laws that may occur in subsequent years.

Considerations before Designating as an S Corp:

1. Eligibility requirements: To qualify as an S Corp, your business must meet specific eligibility criteria. These include being a domestic corporation, having only allowable shareholders (individuals, certain trusts, and estates), and limiting the number of shareholders to 100 or fewer. Additionally, all shareholders must be U.S. citizens or residents. The timeliness of designations is also key, as late designations will have to be explained.
2. Administrative and compliance responsibilities: S Corps have certain administrative and compliance obligations, such as filing annual reports, holding shareholder and director meetings, and maintaining accurate corporate records. These additional responsibilities may require extra time and resources, so it’s important to evaluate whether your business can meet these requirements.

Conclusion:

 Deciding whether to designate your Texas business as an S Corp involves careful consideration of various factors, including the tax advantages, hiring strategies, eligibility requirements, and administrative responsibilities. While pass-through taxation and potential self-employment tax savings make S Corps an attractive option for many business owners, it’s crucial to consult with a qualified tax professional or tax attorney to fully understand the implications and ensure compliance with IRS regulations. The Woodlands Law Firm always advises that businesses consult with a tax specialist before deciding to designate their entity as an S corporation.  However, if you have already decided that designating your entity as an S corporation is something you wish to do, The Woodlands Law Firm can assist you with executing and filing the appropriate paperwork.