S Corporation Election - Part 2 - Cons

The flip side: cons of an S election

A common story I encounter is when a new client comes to me and said that they have already made the S election for their business. At this point I usually cringe a little because they took very general advice from the internet and not usually a qualified CPA who knows their specific facts. The S election is great, but it works better for some fact patterns than others.

Let’s dive in to the downsides of making the S election.

You will notice a theme is that there is more administration to maintain this sophisticated structure vs. having an LLC which is simpler.

1) You have to run payroll

This is the tradeoff for the employment tax benefit. Once you elect S status, you generally need payroll for owner-employees and must have the following. It’s typical to work with a payroll provider to accomplish this.

• payroll tax deposits

• quarterly and annual payroll filings

• W-2 reporting

• reasonable compensation support

  
  

2) You file a separate tax return

S corporations must file Form 1120-S, which is a business return, even though income still passes through to the owners. That means more compliance, more bookkeeping discipline, and tax prep costs. Potentially state returns could apply as well. See #3 next.

3) State taxes can reduce the savings

Federal tax savings do not always tell the full story and it’s important to view the total tax liability including both federal and state. Even if you live in a state with no state income tax such as Florida, Texas, Nevada and Tennessee, operations or activity in another state could create state tax liability and another state return filing. Some states impose:

• minimum franchise taxes

• gross receipts taxes

• entity-level taxes

• separate filing fees

  
  

So even if the federal result looks good, the state result may be less impressive depending on where you operate. The IRS notes that OBBBA affects federal taxes, but state conformity varies, which is one reason entity choice should be reviewed state by state. This is particularly important for entities operating in New York and California.

4) It is not ideal for every growth plan

If you want to reinvest heavily, bring in many types of investors, or position for certain future exits, an S corporation may not be the best long-term structure. In some cases, a C corporation may be more valuable, especially when QSBS rules could apply. See our QSBS article which explains why being a C corporation can unlock significant capital gain benefits for some founders.

Example of when an S-election is not recommended

Let’s walk through an example of when an S election does not always make the most sense.

For example an owner operates as a sole proprietor and is considering making an S election and lives in California. Assume the business earns $40,000 of net profit before owner pay.

Option 1: Sole proprietor

The owner reports the income on Schedule C.

A simple estimate:

Net profit: $40,000

Self-employment tax at about 15.3%: $6,120

Option 2: S corporation

Now assume the business elects S corporation status and pays the owner a reasonable salary of $30,000, leaving $10,000 as a distribution.

A simple estimate:

Payroll taxes on $30,000 salary at about 15.3%: $4,590

Federal employment tax savings compared to sole prop: about $1,530

...So far, that sounds better.

But now add the real-world costs which are commonly not considered when people make the S election. This is what makes the difference when working with a tax advisor.

California S corporation tax: California generally imposes a 1.5% tax on net income, with an $800 minimum franchise tax for corporations or LLCs doing business in the state. This would not apply to a sole proprietor but would apply to a business entity “doing business” in California. Please talk to your CPA if you are not sure what “doing business” in a state means.

• Additional payroll/compliance costs: payroll filings, bookkeeping, and a

separate Form 1120-S tax return often add professional fees and admin costs.

• Reasonable compensation requirement: the IRS requires shareholder- employees who receive cash or property from the S corporation to be paid an appropriate reasonable salary, so you cannot simply set wages artificially low to maximize savings.

What that can look like in dollars

S corporation Vs. sole proprietor estimation

Result -

Even though the S corporation saved about $1,530 in employment taxes, the added state tax and compliance costs pushed the owner to about $770 worse off in this example.

Why this happens

An S corporation often works best when:

• profits are high enough to create meaningful payroll tax savings

• the owner can support a reasonable salary and still have enough profit left over for distributions

• added state taxes and compliance costs do not eat up the benefit

When profit is modest, the S corporation may create:

• too little payroll tax savings

• more filing complexity

• more payroll work

• more professional fees

• extra state-level taxes or franchise taxes

Why S Elections Are Not for Everyone

As you can see S corporation does not always save money. For example, a California business earning $40,000 may save only about $1,530 in employment taxes by electing S corporation status and paying the owner a $30,000 salary. But once you add California’s $800 minimum franchise tax and the extra payroll and tax return compliance costs, the owner can easily end up paying more overall than they would as a sole proprietor. This is what many business owners do not realize unless they work with a tax advisor or have someone paint a picture that is fact specific for each taxpayer.

Remember that was an example for educational purposes and not advice

One more caveat:

Electing S corporation status is not a year-by-year choice, so it should be made thoughtfully with a clear understanding of the payroll, compliance, and ownership rules that come with it. There is no easy undo button for S elections. Revoking the election can also have long-term consequences, including limits on making a new S election again for several years, so businesses should weigh both the short-term tax benefits and the longer-term administrative impact before filing.

Conclusion

The S election also comes with added complexity and ongoing compliance obligations. S corporation owners must pay themselves reasonable W-2 compensation before taking distributions, and state-level rules such as franchise taxes, minimum fees, or nonconformity with federal S corporation treatment can further reduce the overall benefit, making it important to weigh the administrative burden against the potential tax savings.

Curious whether your business is in the right structure?

Book a 1-hour tax strategy session with Meliora Consulting, and we can walk through

your current entity structure, tax position, QBI deduction, and whether an S election

actually makes sense for your business.

Meliora Consulting PLLC | tax advisory