Reasons not to start as an S corporation for a small professional services firm


My understanding is that an S corporation is the easiest for a new firm, and can always be changed to a C corporation later. What are the reasons not to do it this way?

The firm under consideration is in profesional services (primarily consulting) starting with a sole owner, eventually growing organically out of profits.

Also, are there tax reasons to pay out the income as dividends rather than salary?

Incorporation Legal Tax S Corp

asked Nov 3 '12 at 03:29
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There are definitely tax reasons to pay out dividends and not salary (primarily - lower tax rates on qualified dividends, which may expire at the end of the year, and the absence of the FICA and payroll taxes).

However, personal services C-corporations are taxed at higher (flat) 35% rates, which may not be the best rate with lower income corporations. Officers are required to be paid salary in corporations.

As to S-Corp, while you can avoid portion of payroll/FICA taxes, you're required to pay yourself reasonable salary, which, according to recent court decisions, should definitely be at the market level. In a recent decision, an accountant was required to pay himself salary of up to the social security maximum level, essentially rendering (almost) worthless the S-corp savings.

Having said that, unless the law prohibits, you should consider LLC/PLLC. While (taxation-wise) similar to S-Corp, it has the benefit of not requiring paying salaries to self, and less costs associated with maintaining the entity. LLC can be converted to a corporation either for tax purposes or as an entity pretty easily.

Do consult with a lawyer and a tax adviser on all issues.

answered Nov 3 '12 at 03:36
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  • If you're a single-member LLC, then the IRS will pretend that, for tax purposes, the LLC doesn't exist. As a result, you will have to pay self-employment taxes on the entirety of the profits. An S-corp can escape part of this as littleadv described above. – Chris Fulmer 10 years ago
  • @Chris "reasonable salary" claim may invalidate all the savings, depending on what's reasonable in the OP's line of business. As I said, recent court decisions are such that it makes not much sense to create S-Corp unless the income is in hundreds of thousands (then the savings of the medicare tax will pay off over the costs of payroll and additional corp-related expenses). – Littleadv 10 years ago
  • littleadv -- I agree, but the key is 'may.' If you go with an LLC, it's completely unavailable. – Chris Fulmer 10 years ago
  • @Chris Actually, I'm not so sure. First, you can quickly transform the LLC to S-Corp for tax purposes, without reorganizing. Second, there are certain (fairly based) opinions that the tax treatment of LLC income should be similar to the tax treatment of S-Corp/partnership income, i.e.: separate guarantied payments (salary), and fluctuating income over that (non-salary, not subject to SE). People to whom its relevant - reorg to S-Corp anyway, but such a claim has merit (don't know if reviewed by the courts yet). – Littleadv 10 years ago
  • But, those aren't available in a single-member LLC, which is disregarded for tax purposes. (Unless you elect corporate taxation.) Taxing an LLC as an S-corp is certainly an option. – Chris Fulmer 10 years ago

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