If you’re a solopreneur, freelancer, or independent contractor, chances are you have heard about S Corporations (S Corps) and the potential tax savings that come with this tax status. You have also probably asked yourself “Should I become an S Corp? How do I become an S Corp? When’s the right time to make this switch?” Well, the answer to these questions depends less on the calendar or age of your company, and more on your business’s financial milestones. With the right timing, making the S Corp election can be a game-changer for your tax savings and long-term financial health.
What Is an S Corporation?
An S Corporation (S Corp) is not a business entity itself, but rather a tax status you can elect for your LLC or corporation. Choosing S Corp status can help provide:
- Tax savings by reducing self-employment taxes.
- No double taxation, unlike a C Corporation.
- Liability protection, separating your personal and business finances.
- Access to additional tax deductions and retirement plan options.
How S Corp Tax Savings Work
But one of the biggest perks of an S Corp is that you can split your income into two buckets:
- You pay yourself a “reasonable” salary (like an employee).
- The rest of the profits are taken as owner’s distributions.
The salary portion is taxed like normal (subject to payroll and income taxes), but the owner distributions aren’t subject to self-employment tax – which is where the tax savings start to kick in. This setup can result in thousands of dollars in tax savings each year.
When Does It Make Sense to Switch?
So, when does it actually make sense to switch to an S Corp? The best time to consider switching isn’t about as much about a specific calendar date, but rather relates more to your business profits. A good rule of thumb for when the S Corporation election tends to make financial sense is when your business is generating at least $60,000-$80,000 in profit annually.
At those profit level, you should be able to pay yourself a reasonable salary (and cover payroll taxes), as well as start enjoying real savings on distributions not subject to self-employment tax. However, if you are below that profit threshold, the additional costs of compliance (payroll expenses, bookkeeping, tax preparation, etc.) typically outweigh the tax savings.
Can You Switch Mid-Year?
Once you’ve decided you want to elect S Corp status, you don’t have to wait until a certain calendar day or window – you can actually make this election at any point during the year. In fact, converting mid-year is quite common and can help you start saving on taxes right away. Your tax return will simply reflect sole proprietor income for part of the year and S Corp income for the rest.
Even switching in the second half of the year can be worthwhile. While immediate savings may be smaller, you’ll be building good business practices (like dedicated business accounts, payroll systems, and streamlined bookkeeping) that set you up for bigger tax wins in the next year.
Pros and Cons of Becoming an S Corp
As with most things in life, there are pros and cons of making this switch – some of which I have highlighted for you below:
Pros
- Significant tax savings
- More retirement plan options (like higher-contribution solo 401(k)s)
- Stronger separation of business and personal finances
- Greater control over money and planning
Cons
- Must pay yourself a reasonable salary (and handle payroll taxes)
- More complexity: separate tax filings, bookkeeping, and compliance requirements
- Cash flow management is critical to cover salaries and taxes
The Bottom Line
The bottom line is that the “right time” to become an S Corp isn’t about the calendar, it’s about your business’s profit level. Once your business is consistently making around $60,000-$80,000 (or more) per year, it’s worth exploring making this switch.
If you think you’re getting close to this point, it’s smart to sit down with your CPA. They can run the numbers and show you how much you’d save by making the switch.
The sooner you take action, the sooner you start keeping more of your hard-earned money.
For help with your investment strategy, contact us for a free discovery call.