Pretty regularly, people come to us for help with an S corporation they’ve already set up. And that’s fine.
We love helping small businesses. And we love S corporations. No, seriously.
But one unfortunate situation we commonly encounter is where someone with a regular, full-time job sets up an S corporation for a side-line, part-time business.
Usually, setting up an S corporation for a sideline or part-time business doesn’t work.
This post talks about why you usually don’t want to set up an S corporation for a sideline or part-time business if you’ve got a regular, full-time job.
And then, because the subject matter is so similar, this post also talks about the idea of using an S corporation for a very small, part-time venture. Usually S corporations make little to no sense for these ventures, too.
S Corporations Cost More Money
To start your thinking, you need to know that an S corporation increases your accounting and tax preparation costs.
Without getting into all the nitty-gritty details, you probably want to think about the decision as a $1,000 annual expense. And you might end up paying closer to $2,000.
Note: I come up with the $1000 to $2000 by figuring that you’ll pay probably $500 to $1,000 a year to a tax accountant to prepare the annual 1120S corporation tax return. And then I add another $500 to $1000 a year in payroll taxes that you’ll owe even in the case where the only person working in the business is the shareholder.
So keep that $1,000 to $2,000 cost in mind.
Let me also say—and sorry to be a downer—but an S corporation will require you to do a bunch of additional fiddling with your taxes and payroll processing. You may have, for example, two to three extra tax returns you’re doing every quarter of the year.
You Generally Must Pay Some Wages
Here’s the next thing to keep in mind: In order to make your S corporation tax return look reasonable, you’re going to have to pay some substantial chunk of the business profit out to yourself as wages.
The average one-owner S corporation pays its shareholder-employee about $40,000, by the way. So I think most S corporation owners probably want to get close to that number or have a good reason for not being there.
Now what’s weird about this is that in your real job, the full-time one you spend more of your time at, you may already earn a solid wage. But that wage won’t matter.
The comparison you’ll want to make (and it’s the same one I’ll guess the IRS computers likely make) is how your shareholder-employee wages compare to the leftover profits you distribute to the shareholders.
I think, for example, that even if you in your regular job earn $200,000 a year, you need to pay the first big chunk of your business profit as wages.
And another thing—and probably more relevant to the typical small, sideline S corporation: If you make only a modest amount of profit in the venture (keeping in line with the sideline nature of the whole enterprise), I think you probably need to pay out most of the profit as wages.
For example, if you have a part-time business that makes, say, $10,000 or $20,000 a year, logically to me, most of that profit would likely stem from your labor and so should probably be treated as wages.
The bottom line here, then, is that while what you want to do with an S corporation is shield profits from employment taxes, you’ll find it hard to do with a sideline operation.
And these deductions should all work great for small part-time and sideline businesses, too.
To lera more about what tax deductions you can take in your small business, consider our popular downloadable ebook “Small Businesses Tax Deduction Secrets“.
Marginal Employment Tax Rate Matters
And now there’s something else I need to tell you.
Presumably if you’re thinking about an S corporation, you know the attraction of an S corporation.
An S corporation saves a business owner taxes by giving the owner a way to extract profit from the business without paying employment taxes: self-employment taxes, Social Security taxes, Medicare taxes, the Medicare surtax, and so on.
Note: If you want more detail about the mechanics, refer here.
But things can work out oddly for a sideline business operated as an S corporation.
You may, as a practical matter, find yourself shielding very little profit from employment taxes. (This would be the case if you have a very part-time business and feel you need to extract most of the profit as payroll. This often happens if you’re making $20,000 or less.)
And then even if you are able to shield lots of profit from payroll taxes, you need to be sure that you’re not taking profit would have been subject to roughly 3% or 4% employment taxes and subjecting it to a higher employment tax.
In the case where someone already earning the FICA limit operates a sideline business, that business profit if earned in an unincorporated business is subject to employment taxes of roughly 3% to 4%.
But if that person incorporates and elects Subchapter S status, the employment tax rate on the part of the profit that gets extracted as wages will equal at least 10% or 11% and possibly much higher. This weirdness occurs because the FICA, FUTA and equivalent state payroll tax limits get reset or partially reset to zero.
Two Examples Illustrate the Problem
Let me give you a couple of examples so you understand what I mean.
The limits for Federal unemployment tax (FUTA) and state employment tax (SUTA) reset for the new corporation. Accordingly, even if you’ve fully satisfied your unemployment tax obligations in your first, primary job, you may end up paying these taxes again for the next job. FUTA, by the way, can run 6% on the first $7,000 of wages. And SUTA varies by state, but can easily run $1000 or more for an employee.
And here’s another example: While an individual who’s already broken through the FICA limit on one job ($132,900 in 2019) doesn’t need to pay Social Security taxes on the wages from a second job, the employer providing the second job needs to still pay the 7.65% match.
The bottom line here? You will find it more difficult that you would expect to minimize payroll taxes using a S corporation when you’re talking about a sideline business. Sorry.
Summing things up: In most cases, you can’t justify the out-of-pocket costs or the hassle factor of using an S corporation for a sideline business.
You just don’t save enough—in part because the profit values are lower and in part because of the weird interplay between your first full-time job and your second, sideline gig.
By the way: If you still think you might save money with an S corporation via the payroll tax reduction angle, consider buying our “Setting Low Salaries for S Corporations” e-book.
That book explains in detail how the payroll tax savings work for a small business. And that book describes how you can approach the question of “reasonable” shareholder-employee compensation.
What about Part-time Businesses?
Let me throw out one related comment here, too.
Now, again, please understand: We love S corporations. They often work great. Someday, if you have a successful full-time small business, you’ll probably want to operate that venture as an S corporation. Absolutely.
However, all the stuff that causes problems with the S corporation choice for a sideline business probably also causes problems for a part-time business.
You have this relatively high cost you pay just to “play the game.”
Furthermore, you probably have to first pay the “reasonable wages” component out of the profit, which means your business needs to be making something quite a bit in excess of that “reasonable wages” amount in order to even break even on the costs.
An Alternative to the S Corporation Option
Can I make one related suggestion?
If you want to limit your liability, you may want to use a limited liability company instead of an S corporation. We’ve got do-it-yourself LLC formation kits which most people can use to quickly set up an LLC themselves. And note that an LLC can be easily converted to an S corporation at the start of any tax year. Here’s the list of links:
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