As a mental health professional running a private practice, you’re not just responsible for providing top-notch care to your clients—you also need to manage the business side of things. Once your practice reaches a certain income level, you may start hearing about the benefits of electing S-Corporation (S-Corp) status for your business.
But what exactly is an S-Corp election, and is it the right move for your practice? In this blog, we’ll break down the pros and cons of electing S-Corp status, when it makes sense, and how it can save you money in the long run.
1. What Is an S-Corp Election?
An S-Corp is not a business structure like an LLC or corporation, but rather a tax designation that you can elect with the IRS. By default, if you operate your private practice as a sole proprietor or an LLC, your business income is taxed as personal income through pass-through taxation. This means all of your profits are subject to self-employment taxes, which cover both Social Security and Medicare.
However, once your practice reaches a certain level of profitability, electing S-Corp status can offer tax advantages by reducing the amount of income subject to self-employment taxes.
2. When Does S-Corp Status Make Sense?
Electing S-Corp status typically becomes beneficial when your practice starts earning more than $80,000-$100,000 in net income annually. At this income level, the tax savings can outweigh the additional administrative costs and complexities involved with an S-Corp election.
Here’s why:
When you elect S-Corp status, you split your income into two categories:
- Salary: The amount you pay yourself as an employee of your practice.
- Distributions: The remaining profit after your salary is paid.
You only pay self-employment taxes (Social Security and Medicare) on the salary portion, while the distributions are not subject to these taxes. This can result in significant tax savings.
3. The Tax Benefits of an S-Corp
The primary reason to elect S-Corp status is the potential for self-employment tax savings. As a sole proprietor or LLC, all your net income is subject to 15.3% self-employment tax. When you switch to an S-Corp, you only pay this tax on your salary, not on distributions.
For example, let’s say your practice earns $100,000 in net income:
- As a sole proprietor, you would pay self-employment taxes on the entire $100,000.
- As an S-Corp, you could pay yourself a reasonable salary of $50,000 and take the remaining $50,000 as distributions. In this case, you would only pay self-employment tax on the $50,000 salary, resulting in a significant tax savings. 4. What Constitutes a ‘Reasonable Salary’?
One of the most important factors when electing S-Corp status is determining what constitutes a reasonable salary for your position. The IRS requires that S-Corp owners pay themselves a salary that is commensurate with what other professionals in similar roles and industries earn.
If you underpay yourself and take too much of your income as distributions, the IRS could scrutinize your tax return and impose penalties. To avoid this, it’s crucial to work with a tax professional to set an appropriate salary for your role.
5. The Administrative Requirements of an S-Corp
While S-Corp status can lead to significant tax savings, it does come with additional administrative requirements. Unlike sole proprietorships or LLCs, S-Corps must:
- Run payroll and file quarterly payroll taxes for the salary you pay yourself.
- File an annual S-Corp tax return (Form 1120-S), separate from your personal tax return.
- Keep corporate minutes and records, even if you are the sole owner.
These additional tasks may require hiring a payroll service or working closely with an accountant, adding to the administrative costs of your practice.
6. Potential Downsides of S-Corp Election
While the tax benefits can be attractive, S-Corp election isn’t the right fit for every practice. Here are a few potential downsides to consider:
- Increased administrative burden: The need for payroll and corporate compliance can add complexity to running your practice.
- State taxes: Some states impose additional taxes on S-Corps, such as California, Michigan, New Jersey, and New York, which could offset the federal tax savings.
- Salary requirements: You must pay yourself a reasonable salary, which might limit the flexibility of how you allocate your business income.
7. Is S-Corp Status Right for You?
The decision to elect S-Corp status depends on several factors, including your practice’s profitability, your long-term goals, and your comfort level with the added administrative tasks. Here are a few questions to ask yourself:
- Is my practice generating more than $60,000 in net income annually?
- Am I willing to manage the additional payroll and tax filing requirements?
- Do I plan to reinvest a significant portion of my profits into my business or take them as distributions?
If you answered yes to these questions, it might be time to explore the benefits of S-Corp status with your accountant or tax advisor.
8. How to Elect S-Corp Status
Electing S-Corp status can be relatively straightforward, however, we never recommend just elected without professional support. The process includes filing Form 2553, Election by a Small Business Corporation, with the IRS. This form must be filed no later than 2 months and 15 days after the start of the tax year in which you want the S-Corp status to take effect.
Once approved, you’ll need to start following the S-Corp rules, including running payroll and maintaining corporate compliance. Your accountant can help guide you through this process and ensure that you meet all IRS requirements.
Electing S-Corp status can be a powerful tax-saving strategy for private practice owners once your business reaches a certain level of profitability. However, it’s important to weigh the tax benefits against the added administrative responsibilities to determine if it’s the right fit for your practice.
If you’re unsure whether electing S-Corp status is right for you, consult with a CPA who understands the unique needs of mental health professionals, like our team at Flax CPA. They can help you evaluate your current financial situation and guide you through the process of making an informed decision.