When should I make an S-corp election?

You might have heard that switching to an S-corp could save your small business thousands in taxes. Sounds great, right? But how do you know when the right time to make the move is? 

The decision to elect S-corp status isn’t just about tax savings but also timing. If you do it too soon, you could face unnecessary administrative burdens. If you wait too long, you might miss out on major tax advantages. 

This blog will walk you through the key factors that determine the right time to elect S-corp status, helping you make an informed decision that aligns with your business’s financial and operational goals. 

What is an S-Corp and why does it matter? 

An S-corp is a tax designation, not a legal business structure. Your legal structure—whether you are an LLC, sole proprietor, or corporation—exists to provide legal protections and define ownership. Your tax structure, like being taxed as an S-corp, defines how your business income is taxed. 

To ask whether your business is an LLC or an S-corp is like asking whether your cat is a pet or gray. One describes function, and the other describes an attribute. 

But the real reason most small business owners look into S-corps is the potential savings on self-employment taxes. Here’s why: 

When you get your paycheck, money is taken out for income taxes and FICA taxes—the ones that fund Medicare and Social Security. Your employer pays half of your FICA taxes, and you pay the other half, about 7.5% each. When you’re self-employed, you are both the boss and the employee. So congratulations! That means you pay the taxes twice–the full 15% self-employment tax on all your earnings. 

By becoming an S-corp, you must pay yourself a reasonable salary and pay the full 15% employment taxes on that salary. However, any profits above your salary are treated as distributions—not wages—and are subject only to income tax, not employment taxes. That can add up to major tax savings, especially as your business income grows. 

Signs Your Business Is Ready for an S-Corp Election 

Not every business should rush into an S-corp election. Timing matters, and it’s smart to look for the following signs: 

• You’re making consistent profits: If your business is earning at least $40,000 in net income annually, it’s often the point where the tax benefits of an S-corp start to outweigh the costs of additional compliance. 
• You’re paying a lot in self-employment taxes: As a sole proprietor or single-member LLC, you pay both sides of the FICA taxes. With an S-corp, you can take a salary (subject to FICA) and distribute the rest (not subject to FICA), saving thousands. 
• Your business structure allows it: To qualify, you must have a U.S.-based business with no more than 100 shareholders. All shareholders must be individuals, certain trusts, or estates, not corporations or partnerships. This will be explained more later. 
• You’re ready for payroll and compliance: As an S-corp owner who actively works in the business, you must pay yourself a reasonable W-2 salary and handle payroll taxes. If you aren’t ready to set up payroll or track compliance carefully, it may be too soon. 

When to Make the S-Corp Election (Timing Considerations) 

Timing your S-corp election correctly can mean the difference between a headache and real tax savings. 

At the start of the year (best-case scenario): 

The IRS requires you to file Form 2553 within two months and 15 days after the start of the tax year—March 15 for calendar-year businesses. Electing early ensures your entire year is treated as an S-corp, keeping your bookkeeping simple and maximizing tax benefits. 

Mid-year elections (if you miss the deadline): 

If you miss the early deadline, your S-corp election would typically take effect the next year. In some cases, you may qualify for late election relief, but this is not guaranteed. Even if allowed, managing two different tax structures in a year can get messy. Consider whether the benefits for a portion of the year are worth the headache. 

Before a major increase in profits: 

If you expect your revenue to rise sharply—due to a big new contract, client, or expansion—it might make sense to elect S-corp status before the jump. That way, you can shelter some of those extra profits from self-employment taxes right away. 

When restructuring from a sole proprietorship: 

Many small business owners start out as sole proprietors, filing a Schedule C on their personal tax return. As the business grows, shifting to an LLC taxed as an S-corp can offer significant tax advantages while maintaining personal liability protection. 

Potential Pitfalls and Challenges of S-Corp Status 

Before making the leap, be aware of these potential challenges: 

You must pay yourself a “reasonable salary”: 

The IRS requires that you pay yourself a reasonable wage for the work you perform. If your salary is too low, the IRS can reclassify your distributions as wages, hitting you with back taxes, penalties, and interest. It’s critical to pay your fair share into FICA through your W-2 salary. If not, the IRS can hit you with back taxes on ALL the money that flows to you through distribution. So, make sure that you are actually on the payroll and that payroll taxes are being filed appropriately. 

Increased administrative work: 

S-corps involve more complex tax filings than sole proprietorships or single-member LLCs. You will need to file a separate corporate tax return (Form 1120S) and issue W-2s for yourself and any employees. S-corp tax returns typically have higher preparation costs, and you must maintain solid bookkeeping records—no more relying on a box of receipts at tax time. 

Restrictions on ownership and stock:

S-corps come with specific limitations on ownership and how shares are structured: 

• You cannot have more than 100 shareholders  
• Shareholders must be individuals who are U.S. citizens or resident aliens. Certain trusts and estates can also qualify, but corporations and partnerships cannot be shareholders.  
• You can only have one class of stock. That means all shares must confer identical rights to distribution and liquidation proceeds. You cannot create different tiers of stock with varying voting or economic rights, like you might with a C-corp.  

Limiting to a single class of stock can impact flexibility if you plan to raise investment or offer differentiated shareholder rights. If you envision bringing on investors who want preferred treatment or different ownership terms, an S-corp structure may not be ideal. 

Here’s a quick list of who can be shareholders in an S-corp: 

• Individuals: Must be U.S. citizens or permanent residents (resident aliens).  
• Certain trusts: Including grantor trusts, qualified subchapter S trusts (QSSTs), and testamentary trusts.  
• Estates: Including bankruptcy estates and revocable trusts formed through estate planning. 
  
• Exempt organizations: Like 501(c)(3) nonprofits under very specific conditions.  
• Single-member LLCs: Only if the LLC is treated as a disregarded entity owned by an eligible individual.  

If your ownership plans stay simple, these rules won’t cause a problem. But if you plan for complex ownership structures or multiple classes of investors, an S-corp may not be the right fit. 

How to Prepare for an S-Corp Election 

If you think an S-corp election might be right for your business, here’s how to prepare: 

Run a cost-benefit analysis: 

Evaluate how much you can save on self-employment taxes versus the added costs of payroll processing, bookkeeping, and tax filing. 

Set up payroll if you don’t already have it: 

As an S-corp owner-employee, you must process payroll, withhold taxes, and file quarterly reports. Plus, you must be on the payroll. If you don’t have a payroll system in place, you’ll need to set one up before electing S-corp status. 

Consult with a CPA or tax professional: 

Work with an advisor to make sure S-corp status is in alignment with your business goals and to avoid any unintended tax consequences. This is not a decision you want to make without professional guidance. 

File Form 2553 with the IRS on time: 

If you’re making the election for the current tax year, you must file Form 2553 by March 15. If you’re a new business, you must file it within two months and 15 days of your incorporation date. 

The bottom line

The right time to elect S-corp status depends on your profitability, your current structure, and your readiness to handle payroll and compliance requirements. Done right, S-corp status can save you thousands of dollars a year in self-employment taxes. Done poorly—or too early—it can create more headaches than benefits. 

If you’re consistently profiting and paying high self-employment taxes, it’s definitely worth considering whether now is the right time to make the switch. 

Not sure if an S-corp is right for your business? Book a consultation with us to review your numbers and make the best decision.