Introduction
Many small business owners in Washington State ask whether they should elect S-Corporation (S-Corp) status for their company. We often hear something like, “I’ve heard S-Corp saves taxes – should I do it?” The answer depends on each business’s situation. There are indeed benefits to S-Corp status (such as distributions of profit not being subject to self-employment tax), but there are also pitfalls if you don’t meet the requirements (for example, paying yourself too small a salary can lead to IRS penalties). This article will explain what S-Corp status means, compare it briefly to other business entity types, and outline the pros and cons of electing S-Corp status (including for LLCs taxed as S-Corps). We’ll also highlight Washington-specific considerations, since most of our clients operate in Washington State.
By the end, you should have a clearer overview of S-Corp advantages and disadvantages, and why we generally advise waiting to elect S-Corp until you’ve consulted a professional about your specific situation. Remember, this is general information – for personalized advice, please discuss with a CPA or tax advisor.
Business Entity Basics
Before diving into S-Corps, let’s briefly review common business entity types for context:
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Sole Proprietorship: A one-owner business with no separate legal entity. Profits are taxed on the owner’s personal tax return, and the owner pays self-employment tax on all business net income. No liability protection.
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Partnership: Two or more people share ownership. Income passes through to partners who report it on their personal returns. Partnerships file an informational tax return (Form 1065). No liability protection unless structured as an LLC.
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Limited Liability Company (LLC): Offers liability protection and flexible taxation. Can be taxed as a sole proprietorship, partnership, S-Corp, or C-Corp. In Washington, forming an LLC costs about $200, with an annual report fee of around $60.
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C-Corporation: A separate legal and tax entity. Profits are taxed at the corporate level and again when distributed as dividends (double taxation). Suitable for larger companies with investors. Subject to Washington’s B&O tax.
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S-Corporation (S-Corp): A tax election available to corporations and LLCs. Profits pass through to owners’ personal tax returns. Must meet IRS eligibility rules: ≤100 shareholders, one class of stock, U.S. citizens/residents only.
What Does Electing S-Corp Status Mean?
Electing S-Corp status means choosing to have your business income taxed under Subchapter S of the Internal Revenue Code. Both corporations and LLCs can elect S-Corp taxation if they meet the criteria.
Key Features:
- Pass-Through Taxation: No federal income tax at the entity level. Profits/losses flow through to owners’ personal returns via Schedule K-1.
- Self-Employment Tax Savings: Owners pay FICA tax only on salary. Distributions are not subject to self-employment tax.
- Reasonable Compensation Requirement: Owners must pay themselves a fair salary for their work.
- Compliance Requirements: Must file Form 1120S annually, issue K-1s, run payroll, and maintain records.
- Eligibility Limits: ≤100 shareholders, one class of stock, U.S. individuals only.
Pros and Cons of S-Corp Election
| Pros | Cons |
|---|---|
| Self-Employment Tax Savings: Distributions not subject to FICA taxes can save thousands annually. | Payroll Complexity: Must run payroll and file payroll tax reports. |
| Pass-Through Taxation: Avoids double taxation. | Additional Costs: Higher CPA fees, payroll service costs, and bookkeeping. |
| Liability Protection: Retains LLC or corporate legal shield. | Strict IRS Rules: Must follow shareholder and stock class limitations. |
| LLC Flexibility: LLCs can elect S-Corp without changing legal structure. | No WA State Tax Advantage: B&O tax still applies; no personal income tax savings. |
Washington-Specific Considerations
- No Personal Income Tax: S-Corp election offers no state income tax benefit in WA.
- B&O Tax: Applies to all business entities, including S-Corps. Based on gross receipts.
- Annual Reports: Required for LLCs and corporations. ~$71.50 filing fee.
- Payroll Taxes: Must register with WA Employment Security and Labor & Industries if running payroll.
- Professional Entities: Licensed professionals may need PLLC or PC status before electing S-Corp.
Conclusion
S-Corp status can offer meaningful tax savings, especially for profitable businesses. But it also introduces complexity, compliance obligations, and costs. In Washington, the benefits are primarily federal – there’s no state income tax advantage, and B&O tax still applies.
We recommend consulting with a CPA before electing S-Corp status. A personalized analysis can help determine whether the savings outweigh the costs and whether your business is ready for the added responsibilities.
Need help deciding if S-Corp is right for you? Reach out to our team for a tailored consultation.
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Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Please consult a qualified professional for guidance specific to your situation.