BUSINESS MANAGEMENT SERVICES

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As a sole proprietorship becomes more profitable, self-employment tax becomes one of its largest expenses. Unlike income tax, which is based on your marginal rate, self-employment tax applies at a flat 15.3% on net earnings — 12.4% for Social Security (up to the annual wage base) and 2.9% for Medicare, with an additional 0.9% Medicare surtax for higher earners.

An S-Corporation can reduce this burden by splitting business income into two components: a reasonable salary (subject to payroll taxes) and distributions (which are not subject to self-employment tax). When structured and managed correctly, the payroll tax savings can be substantial.

However, the S-Corporation election is not a simple switch. It introduces compliance obligations, changes how certain tax benefits are calculated, and carries costs that must be weighed against the savings. The analysis is specific to each client's facts and circumstances — there is no universal income threshold at which an S-Corp automatically makes sense.

Before recommending an entity change, we evaluate several factors that affect whether the S-Corporation election will produce a net benefit for your specific situation:

Self-employment tax savings. The core benefit. By paying yourself a reasonable salary and taking remaining profits as distributions, you reduce the income subject to FICA taxes. The savings depend on your net profit level, the salary the IRS would consider reasonable for your role and industry, and whether your income exceeds the Social Security wage base.

Qualified Business Income (QBI) deduction impact. Under IRC §199A, eligible business owners can deduct up to 20% of qualified business income. When you elect S-Corp status, the W-2 salary you pay yourself is excluded from QBI — which reduces this deduction. For many clients, the FICA savings exceed the QBI reduction, but this tradeoff must be calculated, not assumed.

Reasonable compensation requirements. The IRS requires that S-Corp shareholder-employees pay themselves a reasonable salary before taking distributions. A salary that is too low relative to the work performed and industry norms invites scrutiny and potential reclassification of distributions as wages — which eliminates the tax savings and may trigger penalties.

State tax considerations. California imposes a 1.5% franchise tax on S-Corporation net income and an $800 minimum annual franchise tax. These are additional costs that do not apply to sole proprietorships and must be factored into the analysis.

Compliance and administrative costs. An S-Corporation requires payroll processing, quarterly payroll tax filings, corporate minutes, annual state filings, and more rigorous bookkeeping. These are real, ongoing expenses that offset a portion of the tax savings.

Retirement plan opportunities. S-Corporations open the door to employer-sponsored retirement plans — including SEP-IRAs and Solo 401(k) plans — where the company can make tax-deductible contributions on your behalf. Contribution limits and mechanics differ from sole proprietorship retirement plans and can be a significant planning lever.

Health insurance deduction. S-Corp shareholder-employees who own more than 2% of the company can deduct health insurance premiums, but the premiums must be included on the shareholder's W-2 and handled through a specific reporting process to qualify.

The S-Corporation election is not appropriate for every business. Situations where it may not produce a net benefit or may not be available include:

• Businesses with net profits that are not yet consistently high enough to offset the additional compliance costs
• Businesses that need multiple classes of stock or flexible ownership structures (an S-Corp is limited to one class of stock and 100 shareholders)
• Businesses with non-resident alien shareholders (not permitted under S-Corp rules)
• Businesses planning to seek venture capital or private equity investment (investors typically require C-Corp or LLC structures)
• Sole proprietors whose QBI deduction benefit would be significantly reduced by the salary requirement

We perform a comprehensive analysis before recommending any entity change. If an S-Corporation is not the right fit, we will tell you — and we will explain why.

When an S-Corporation is the right choice, we manage the entire process and ongoing compliance so you can focus on running your business:

• S-Corp formation and election — entity setup, Articles of Incorporation or Articles of Organization, IRS Form 2553 election filing, and EIN registration
• Corporate compliance — annual reports, corporate minutes, and state filings
• Payroll processing — reasonable compensation determination, payroll tax filings (federal and state), W-2 preparation, and quarterly returns
• Bookkeeping — double-entry financial statements, bank reconciliation, and month-end or quarter-end close
• Tax preparation and planning — S-Corp return (Form 1120-S), individual return coordination, estimated tax planning, and year-end strategy
• Retirement plan coordination — SEP-IRA or Solo 401(k) setup guidance and contribution optimization
• Correspondence and notices — we respond to all notices from the IRS, FTB, EDD, and other tax authorities on your behalf

Our entity management packages are customized to each client. Contact us to discuss your current situation and we will provide a detailed analysis showing whether the S-Corporation election would produce a net benefit for your business.