There seems to be a lot of confusion and uncertainty surrounding what it means to be taxed as an S corporation, and when you might want to make that election.
Both an LLC and a C-Corporation can make the election to be taxed as an S corporation. An S-Corporation is what is considered a pass-through entity, meaning any income or loss incurred by the business is passed through to the owners personal tax return.
LLCs operate in a similar fashion. If it is a multi owner LLC, then a partnership tax return is required. The partnership tax return also does not pay tax but rather passes on the income and expenses to the partners based on ownership percentage. A single member LLC is the same as a sole proprietorship. Income and expenses are reported on a schedule C which attaches to the personal tax return and no other business tax return is necessary.
S corporations, in and amongst themselves do not pay tax. I think that’s how some people get away with saying they pay no income tax or advertising that they can find ways for your business to pay zero income tax. It is true that that particular entity structure does not pay tax within itself, but it’s rather misleading in that profits of the business are taxable at the personal level.
However, there are still some great tax savings opportunities within the S corporation that can help reduce the taxable income substantially while allowing owners to save large amounts of money for retirement, reimburse themselves for home office and auto expenses, and other more advanced tax savings strategies.
One big requirement of the S Corporation that is often overlooked is that owners must take a reasonable salary from the business if they are actively working in the business. There are entire companies built around reasonable compensation analysis, where they will look at what you do in detail within the company and provide an exhaustive report of what they believe you should be reasonably compensated. Personally, I don’t believe it needs to be that difficult. Usually what I tell my clients is to research how much they would need to pay to hire someone else to come in and do what they do. That could also be considered reasonable compensation in my opinion.
I usually advise my clients to start thinking about the S Corp. election when their business nets 100,000 or more. Different professionals have different thresholds that they advise. I’ve heard others recommend the S Corp. election with net income as low as 60,000. There may be certain circumstances where that might be of benefit, however I usually find that by the time you take into account the extra costs that come with making the S Corp. election, such as the separate business tax return, which usually starts around $2000, and the need to run payroll and hire a bookkeeper, the tax savings can be eaten up pretty quickly if the profits weren’t there to begin with.
When electing to be taxed as an S corporation it becomes more important to not only track income and expenses (profit and loss statement), but also owners equity and liabilities (balance sheet.)
To summarize, my personal recommendations for electing SCorp status are as follows:
Business has at least one year netting $100,000 or more or anticipates that amount of income after expenses in the first year.
You have already established a professional bookkeeper and have a clean set of books.
You have a written operating agreement in place for your business.
You are already set up with payroll for other employees in the business or you are prepared to hire a payroll company to begin paying yourself on payroll.
You are prepared to spend an additional $2000-$5000 on tax preparation of the corporate tax return, and understand that the deadline for the business return is March 15th, not April 15th.
You are prepared to set up an accountable plan for your S Corporation so the business can reimburse you for home office and mileage expenses.
If you check all these boxes and would like to discuss what it would take for your business to be taxed as an S Corporation, I’m available for online advisory and consulting appointments. You can self schedule online here and don’t forget the cost of the consult is also tax deductible!
If you’re still reading and your eyes haven’t glazed over yet, the last thing I’d like to explain is where the tax savings comes from via electing S Corp status.
A single member LLC, a sole proprietor, or even partners in a partnership all pay self-employment tax, which means they are paying their own Social Security and Medicare tax on their earnings.
Usually, when you work at a W-2 job, you are responsible for half of those taxes and the employer covers the other half for you, so the amounts you see withheld from your paycheck are only half of what is actually being paid in on your behalf.
When you are self-employed, you are responsible for paying those taxes yourself which totals 15.2% percent of your net income.
This is in addition to any regular federal and state income tax you might owe.
Without the S Corp election, all of your net income is subject to that additional tax. By electing to be taxed as an S corporation, you then must pay yourself a reasonable salary, which hopefully is quite a bit less than what the company is actually earning/netting.
Now essentially, the salary portion of your pay is still taxed in the same way as if you had not made the election. It’s just handled a little differently because now instead of paying the entire Social Security and Medicare Tax yourself on your personal return, instead your business is now paying you on payroll and withholding half the tax from your pay and matching the other half, so essentially you are still paying the same amount of tax on that portion of your earnings - however it’s the earnings above and beyond your salary that get the most tax savings because now those amounts are taxed as distributions and are only subject your regular income tax rate, not to the Social Security and Medicare Taxes. If we’re talking about $50,000 in distributions for example, that could be a tax savings of $7500.
If you take $50,000 and add it to what you feel you should be reasonably compensated for the job you do within your company, and the number you come up with is less than what you are currently netting than it would be my recommendation to start thinking about making this election.
Let’s have a conversation!
I know this is a lot but that’s why I’m here to help. Make a list of your questions and let’s hop on a zoom together to get you on the path to tax savings!
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