Blog

S-Corp See-Saw: Weighing the Pros and Cons of S-Corp Election for 1099 Contractors

S-Corp See-Saw: Weighing the Pros and Cons of S-Corp Election for 1099 Contractors
Written by
John Foote
Published on
23 Nov
2024
Credit
Illustration by Freepik
Copy link
    • S-Corp See-Saw: Weighing the Pros and Cons of S-Corp Election for 1099 Contractors
      ‍
      Financial professionals quickly recommend S-Corp election to 1099 self-employed independent contractors to reduce payroll taxes. When a business elects S-Corp status, the owner pays themselves a W-2 salary, and the remaining profits are taken as a distribution. Payroll taxes are only applied to the W-2 salary—meaning the distribution portion avoids these taxes. In contrast, a sole proprietor pays payroll taxes on the entire net profit because there’s no W-2 salary to separate.

      While this S-Corp strategy does indeed lower payroll taxes, it isn’t a one-size-fits-all solution. There’s a careful balancing act to be considered, or what I call the S-Corp "see-saw," between saving on payroll taxes and potentially reducing other tax benefits.

      ‍‍

    See-Saw #1: Retirement Contribution Limitations

    Lowering your W-2 salary to reduce payroll taxes also reduces the potential for retirement contributions. Employer contributions to a Solo 401(k), for example, are capped at 25% of your W-2 salary. So, while you're saving on payroll taxes by setting a low salary, you're also capping how much you can contribute to your retirement plan.

    In practice, many owners elect S-Corp status to reduce payroll taxes but then aim to maximize retirement contributions. This often leads them to increase their W-2 salary to allow for larger contributions—negating the initial goal of minimizing payroll taxes. It's one of the key balancing acts in play when considering S-Corp taxation.

    ‍

    See-Saw #2: The QBI Deduction

    Another key consideration is the Qualified Business Income (QBI) deduction, also known as the Section 199A deduction. This deduction is typically 20% of your QBI. For S-Corp owners, the W-2 wages you pay yourself and the retirement contributions you make are excluded from QBI. As a result, these amounts lower your QBI, reducing your potential Section 199A deduction.

    • In contrast, a sole proprietor would likely have a higher QBI deduction, as there's no W-2 wage to reduce the calculation. So, while S-Corp status saves you payroll taxes, it might lower your Section 199A deduction. This is another case where running the numbers to determine your total tax liability is crucial. If you're below the taxable income threshold, a sole proprietorship might work better for maximizing your QBI deduction. Kitces offers more insights on this.

      To further complicate the decision, if your taxable income exceeds the QBI phase-out thresholds, increasing W-2 wages through an S-Corp may actually help maximize the deduction. This is because, at higher income levels, the QBI deduction is partially determined by W-2 wages paid, which means a higher salary can provide tax benefits in certain scenarios. Therefore, your decision to elect S-Corp status depends heavily on your income, wage structure, and overall tax liability projections. Projections and scenario analysis are crucial for an informed decision.
    • See-Saw #3: Mixing W-2 Employment and 1099 Self-Employment
      ‍
      ‍      If you have a W-2 job in addition to your 1099 side gig, electing S-Corp status for your self-employed income might not be advantageous.

      Here's why: Social Security taxes have an income cap ($176,100 for 2025). If you’re already paying Social Security taxes on your W-2 income, you may end up overpaying by setting up an S-Corp for your side job, because the employer portion of Social Security taxes won’t be refunded to you. While you can reclaim the employee portion on your tax return, you, as the S-Corp employer, won’t get a refund for your portion of the overpaid Social Security tax.

      If you were taxed as a sole proprietor, you wouldn’t be responsible for additional Social Security taxes on income above the cap. This makes the sole proprietor option potentially more attractive for those with both W-2 and 1099 income. White Coat Investor provides a deeper dive into this issue.‍
    • See-Saw #4: Fees and Additional Taxes
      ‍
      Running an S-Corp can come with extra costs. These may include payroll processing fees, increased tax preparation fees, and possible state or local corporation taxes. For instance, New York City imposes an 8.85% General Corporation Tax on S-Corps, which could significantly impact your total tax bill. It’s important to weigh these fees against your potential payroll tax savings.

      Conclusion

      None of these considerations should automatically dissuade you from electing S-Corp status. Even with the limitations on retirement contributions, the reduced Section 199A deduction, and the added costs, S-Corp elections may still result in the lowest overall tax liability. But it's essential to run the numbers. Your situation—particularly your retirement goals, W-2 employment status, and income level—will determine whether S-Corp status is right for you.

      It's important to avoid the assumption that S-Corp is always the optimal choice. A professional analysis is essential to ensure that you're making the best decision based on your unique circumstances.

      Additional Resources:
      ‍

    ‍

    View all posts