Analysis: The Tax Desk

Los Gatos: Every owner hears it eventually, usually at a barbecue. "You should be an S corp." Sometimes that is good advice. Often it is half of it. Here is the whole thing, with one made up example and no tables that will go stale by next year.

Start with the plain LLC owned by one person. For income tax it is usually treated like a sole proprietorship. The profit lands on your personal return, and all of it is also subject to self employment tax, which is how owners pay into Social Security and Medicare. That second tax is the part people want to shrink.

An S corporation election changes how the profit is split. You become an employee of your own company and pay yourself a salary. The salary carries payroll taxes, the same as any employee. What is left after the salary can come out as a distribution, which does not carry those employment taxes.

"The saving lives in the gap between your profit and a fair salary. No gap, no saving."

From the tax desk

So the whole question is the gap. If your business earns a modest profit and a fair salary for your work would eat most of it, there is little left to distribute, and the election saves little or nothing. If your profit is well above what a fair salary would be, the gap is real, and so is the saving.

An illustration, with round numbers we made up. Say a business earns $100,000 in profit, and a fair salary for the owner's work would be $60,000. That leaves a $40,000 gap. Assume both figures sit under the yearly wage cap on the Social Security part, and ignore income tax, which is mostly the same either way. Employment taxes run roughly 15.3 percent in total, so on that $40,000 gap the difference is about $6,100, before the costs below take a bite. Change the profit, the salary or the year, and the answer moves a lot. It is a picture, not a forecast.

Where employment taxes apply

Illustration only, same profit, two setups

Now the costs. An S corporation runs payroll, even for one person. It files its own return, separate from yours, which costs more to prepare. California charges its own minimum and entity level taxes, and some owners lose a little on benefits and retirement math. These costs are steady whether the year is good or bad.

Then the word that matters most: reasonable. Your salary has to be fair for the work you do. Paying yourself almost nothing to stretch the gap is the classic mistake, and it is the one that draws questions. We look at what people in similar roles are paid and land on a number you could explain to anyone.

Our rule of thumb, which is a starting point and not advice: if profit has been steady for two years, comfortably above a fair salary, and you work in the business full time, it is worth running your real numbers. If any of those is shaky, stay simple and look again next fall.

That comparison is exactly what the October planning meeting is for. Bring your last two returns and this year's books. We will run both setups side by side and tell you plainly which one wins, including when the answer is "not yet". This is general information, not tax advice, so talk to a tax preparer about your own numbers before you change anything.