This is Part 3 in a series of ours. If you have not read our previous articles do that first:
In this article we are going to talk about what an S Corporation is and why you may want to elect to be taxed as one.
1. What is an S Corporation?
An S Corp is a way to be taxed. It is not a entity type at the state level. In order to be an S Corporation your business must be an LLC or Corporation. You then elect for that business to be taxed as an S Corp.
This is important, in order be an S Corp you need to have an entity structure already setup. If you are operating as a Sole Proprietor you would not be able to elect S Corp status, you would first need to open an LLC or Corporation.
If you elect to be taxed as an S Corp it does not change your entity structure at the state level. If you are an LLC and elect to be taxed as an S Corp you remain an LLC with your state, nothing changes on the entity setup level.
2. Where do I report activity from a S Corporation?
As discussed in our previous article a S Corp is considered a pass through entity. You report the business activity on a business tax return (Form 1120S) which would include a K1 that you use to bring it to your personal return.
Note: As a Single Member LLC you simply file your business activity on your personal tax return (1040) via a Schedule C but with an S Corporation you are required to file a separate business tax return which will then flow to through your personal return.
3. Payroll Requirement for S Corporations
The IRS requires owners of an S Corporation to take a “reasonable salary”. This means you will be an actual W2 employee of your business. If you have other employees this is not a huge deal but if you are a solo business owner you will need to implement a payroll service to help make sure this is done quickly and easily. We recommend Gusto for a painless payroll experience.
4. How is a S Corporation taxed?
As a S Corporation there is no federal income tax at the corporate level instead your pay taxes on the business income on your personal tax return. You will pay your normal income tax rate on the income from the S Corporation and you will pay “self employment taxes” on your salary from the S Corp.
Regular Income Tax Rate: This would be your normal rate that you pay on all ordinary income including a W2 from an employer.
Payroll “Self Employment Tax”: With an S Corp you pay self employment taxes on the payroll you take as an employee. They do not call it self employment tax directly but that is essentially what it is because you pay social security and medicare taxes as both an employee and then you as an employer matches it.
If we compare this to a Sole Prop or SMLLC you can see the advantage is that instead of paying self employment taxes on 100% of your income, you only pay it on the payroll portion but any other earnings from the business are just taxed at your normal income tax rate.
Essentially you split your business income into two: Payroll and Dividends (or owners draw)
Lets put this in an illustration:
5. Let’s see an example!
Everything makes more sense when you put some numbers to it. So lets look at an example. In this example we are using business profit of $80,000 and we are assuming a reasonable salary would be $36,000.
In this example with $80k of business profit if you were setup as a SMLLC you would pay $11,304 in self employment taxes, again this is in addition to your normal income tax rate.
However, with an S Corporation we are only paying self employment taxes on our payroll of $36k which would be $5,508. The remaining $44k from our profit would not be subject to self employment taxes, leading to tax savings of $5,796.
Note: The remaining $44k you would pay your normal income tax rate on and take (if you wish) as a dividend simply by transferring the funds (or writing a check) from the business account to your personal account.
This self employment tax savings is one of the main reasons we look to an S Corp for small business owners.
6. When does it make sense to elect to be taxed as an S Corporation?
An S Corporation is not right for everyone. Typically we say if your business profit is roughly $40k or more the S Corporation could make sense for you. The reason we set this threshold is because there are some added costs to an S Corp (which we discuss below), that will eat into your tax savings if below this amount.
We would never advise someone to rush into an S Corp if the additional costs to maintain it will wipe out the savings.
Note: Some cities and states (New York City, Tennessee, etc) are not friendly to S Corporations, so double check an S Corp makes sense in your specific situation prior to making any changes. There are also some requirements that need to be met in order to elect S Corp status which we will discuss in a future article about setting up the S Corp.
7. What are the downfalls to being an S Corporation?
As mentioned above if you are not profiting $40k+ some of the costs of an S Corp could eat up your tax savings. Here are the two main downfalls of an S Corporation:
- Separate Business Tax Return is Required: Unlike a Sole Prop or SMLLC which are simply filed on your personal tax return via a Schedule C, with an S Corp you have to file a separate S Corp Business Tax Return on Form 1120S. This tax return is more complicated than a Schedule C and thus costs more to prepare. Fortunately, all of our packages includes the S Corp tax return in them.
- Payroll (Reasonable Salary) is Required: If you already have employees adding another one (yourself) is not a big deal. However if you do not currently have employees you would need to setup a payroll system so you can properly withhold taxes, file payroll tax returns, and pay the respective taxes to the government agencies. This brings a hard cost which typically ranges from $50-$120 per month.
Assuming you live in an S Corp friendly city and state (most are) these would be the only main downfalls.
Another nice feature of the S Corp is that the audit rates are significantly less compared to a Schedule C filing.
In our next articles we are going to discuss what a “reasonable salary” means and how you can go about electing S Corp status for your business.
If you don’t have a tax advisor, consult with one prior to make this change to ensure it makes sense for you and your business. Click here to book your complimentary strategy session with JETRO.