S Corp Disadvantages That Can Harm You - 6 Drawbacks You Need to Know.

Introduction to disadvantages watch from 0:00

Welcome back to our channel, ClearValue Tax. My name is Brian Kim, I'm a certified public accountant, and in today's video we will be discussing the drawbacks of an S corporation. So we're talking about the S Corp disadvantages. I'm sure you can find a whole slew of videos out there talking about the greatness and the benefits of the S Corp, just saying it's the greatest thing. However, that depends on your situation. So we're gonna be providing you the drawbacks of the S Corp so you can have all the information at hand to make the best decision on whether it's right for you. So I'm gonna list them out here first, and then we're gonna go into details about each one.

So here's the list of the drawbacks. So you will have potentially reduced Social Security benefits upon retirements. There's the additional cost of the tax return of the S corp. There's a chance, depending on [where] you are operating out of, that you will be subject to state income taxes at the corporate level, which you wouldn't have paid as a sole proprietor. There's the payroll software costs. There's a unemployment taxes at the state level, and also the FUTA, the federal unemployment taxes as well. And just the cost of your time, just you going through all these additional compliance motions. Okay, so let's dive into the Social

Reduced social security watch from 1:20

Security benefits. So let me show you how this works. So do you even know how is the Social Security benefits are calculated? So this is what happens. Each year there's a certain amount of your income that's subject to Social Security taxes. We're talking about if you're self-employed, even if you're an employee getting a W-2, there's a certain amount of income that's subject to Social Security taxes, currently at a rate of 6.2%. Okay, so there's a maximum of the amount that is subject to Social Security taxes per year. There's an annual maximum, they call that the wage base ceiling. So in 2020, up to a hundred thirty seven thousand seven hundred is subject to Social Security taxes.

Okay, so if you make over that amount, you're no longer going to be subject to Social Security taxes on your income. So a lot of you who are making over that amounts during the year, you might notice that you get a big net pay bump and don't know why. That's because that means you've made over that amount in that year, and you're no longer being charged at six point two percent, therefore your net paychecks bigger. That's because at a certain point, which is adjusted for inflation each year, you stop paying Social Security taxes because you've paid in the maximum amounts for that year. Okay, so the way it works, how you calculate your Social Security benefits, it's based off your highest 35 years, your highest 35 years of income.

There's a calculation that's being run, but to just give you a high-level overview, they look at your highest grossing 35 years, and based off how much you've paid into the system, your how much Social Security taxes you've paid, that's how your benefits are calculated. So with the S corporation, perhaps you know, perhaps you don't, where's the bulk of the savings coming from in comparison to operating as a sole proprietor? You are saving the bulk of your money operating as an S corporation by paying less Social Security taxes. So how is that gonna affect you? If you're paying less Social Security taxes into the system, remember, that's how they're calculating your benefits, your Social Security benefits upon retirement.

They're looking how much you pay into the system for the past 35 years, the highest or at 35 years, and if you're paying less into the system with Social Security taxes, well, your benefits will be reduced then. So if you did not know this, I hope you learned something. If you have, please give me a thumbs up or like, that highly appreciate that, that helped our channel. And okay, I hope that's a revelation to you if you didn't know that, because the bulk of the savings is coming from paying less Social Security taxes. How is that gonna affect you? That affects you negatively, the Social Security benefits [upon] retirement. Okay, so moving on to the next one. As an S corporation,

Tax filing requirements watch from 4:41

you are filing a separate tax return, a separate 1120-S S corporation income tax return. So the way you are filing before, as a sole proprietor, you were filing just on an additional schedule on your individual income tax return. So you're filing your business activity on your personal income tax return as a sole proprietor. That's no longer the case with an S corporation. With an S corporation, it's a legally separate entity that needs its own tax returns. So you're going to be filing a separate corporate tax return. So however you're going to be doing this, if you're gonna buy at home software to do this, I mean, that's still gonna run you probably about a hundred to two hundred dollars for the software costs.

Or if you're gonna work with an accountant, you might be paying five hundred [to] two thousand dollars for this corporate tax return, depending on where you live and accountants, whatever they're charging. It might be less, it might be more, but that's typically on average what they will be charging for this S corporation tax return. So while we're talking about

Additional state taxes watch from 5:53

the tax returns, you know, one additional cost that might be applicable to you, depending on where you live. I'll give you an example. So if you're in Chicago, your corporation, your S corporation will pay an additional corporate tax at a rate of 1.5%. It's not the biggest, but that's still an additional 1.5 percent corporate tax at the business level. This is something that you as a sole proprietor would not be subject to, because you were not operating as a corporation. But as an S corporation, in certain states you will be subject to an additional [entity]-level tax. So you need to take that into consideration. As an S corp, again, a lot, the pretty much the bulk, or all, the tax savings is coming from the reduction of Social Security Medicare taxes, which is self-employment taxes to the sole proprietor. But anyways, it's about income

Payroll software costs watch from 7:02

classification. Please check out our other videos going more in depth at in detail about that. But you're doing that with the manipulation of income classification, with salary on payroll versus your business income, your dividend distributions. So with that, you need a salary. With that, you need a payroll system. We have a whole separate video about the payroll, the payroll set up and all that too. But with the payroll system, expect a monthly software cost of whatever payroll provider you're choosing. Expect the monthly software costs about $25 a month to $50 a month. You know, the, again, in the other videos we'll discuss the beauty, but to recap, you know, they keep, they take care of all the filing requirements, the quarterly reports, the tax deposits, that W-2 creation, all of that.

So I mean, it's worth it. However, you're still gonna be forking over twenty-five to fifty dollars a month for the payroll software costs. So that's an additional cost that you would not have as a sole proprietor. Another

Unemployment taxes watch from 8:11

thing is that this is based on your state as well. With an S corporation, you will be an employee of your S corporation, you will be an employee shareholder. So if you are illegal, if you are a legal employee of your business, in most states you'll need to pay state unemployment taxes on yourself. Your business will need to pay state unemployment taxes on you as the employee. So this is going to range from state to state, per person, per firm, per employee, but generally you're talking about state unemployment tax is about 200 to 500 dollars a year. However, depending on the states, a lot of states, that cost drops down to as low as $30 a year or $50 a year per employee, per person, if you have a good record of not laying your employees off.

So it's long as you don't lay yourself off. But usually you need to build a track record of about three years for that unemployment cost to be reduced. So from your year one and subsequent years, until you reach that point, expect to pay state unemployment taxes, which is an employer tax on yourself, for about two hundred to five hundred dollars annually. Okay, and okay, I mean, those are the major costs,

Compliance and final advice watch from 9:35

but then going through all this compliance work, you know, we're talking about, okay, even if you have [an accountant] doing your tax return, well, you still need to do the communication with the accountant. You need to go through all those motions. And even running the payroll, you know, if you're gonna be doing payroll yourself, you know, you're gonna be running through those motions, and that's gonna be eating up your time. These are things that you wouldn't have to have done if you are not an S corporation. So you need to take all these things into consideration and weighing the pros and cons to decide whether it's worth it to be an S corporation.

Now listen, in this video I'm talking about only the negative things. So this is like a Debbie Downer video, this is she's talking about the negatives. You know, there are so many advantages and benefits to being an S corporation, you can see our other videos, but you need to weigh both sides of it. But ultimately, what is it boiling down to? It's how much taxes are you going to save as operating as an S corporation, and what are the costs. So if you're going to be saving $10,000, $15,000 operating as an S corporation, then I would say yes, you know, these costs of the S corp, these disadvantages of the S corp, you know, it's gonna be totally worth it.

The benefits will outweigh the costs. However, in a situation where your tax savings what the S corp will be about, you know, this is just my opinion, if your savings will be about two thousand dollars, you know, three thousand dollars, it won't be worth it, at least not to me, not money, not from my point of view, because you have all these additional costs that you wouldn't be paying if you weren't operating as an S corp, and the additional time. You know, what's the net dollar benefit? You know, it's going to be a thousand dollars, or maybe even a few hundred dollars. You know, in that situation, it just wouldn't be worth it to me.

You know, if your tax savings is in the realm of four thousand, seven thousand, eight thousand, that, you know, that's kind of a middle ground. You know, that's that's kind of an area where it's not clear-cut, where it's clear-cut [unclear] clear-cut don't be an S corp. In that situation, you need to just, you know, it's your purpose personal preference, you know, to weigh the pros and cons and see whether it's worth it to you. Okay, so I hope that this video has been helpful, because a lot of times people are not going to be talking about the disadvantages of an S corp. If you have any questions or comments, please leave them below, I'd be happy to get back to you. And again, if you found this video helpful, please give me a thumbs up, I'd highly appreciate that, and though it helped the channel a lot. Thanks so much, until next time, take care.