I get asked almost daily if an S Corporation is a good fit for their business and I can tell you that there is a lot at stake. So much so, that it is well worth your time to know the basic differences between an S Corp and LLC before you ask a licensed professional for a recommendation. You are the captain of your own ship! You need to be able to determine if your professionals are advising you under standard and well recognized basic concepts.
Surprisingly there are advisors across the country that miss the mark and give truly damaging advice that costs small business owners thousands of dollars. Here are five of the major factors that the lawyers at our office considers when making a recommendation of an S Corp to clients.
Before proceeding further, I would like to clarify that when you have an LLC ‘taxed as an S Corp’, that is the same thing as a standard S Corp. For tax purposes they are the same thing. One benefit of an LLC is that you can start your business under the structure of an LLC and then ‘convert’ it to an S Corp when the time is right. This is actually a very affordable process. Until the ‘election’ is made to convert, the LLCs is taxed as a sole proprietorship or partnership.
Benefits of an S Corporation
The main benefit of an S Corp is it’s liability to legally, honestly and ethically reduce Self-Employment Tax (SE Tax). SE tax, also referred to as FICA, consists of Medicare and Social Security taxes totaling a 15.3% hit on your bottom line. In a sole prop or an LLC taxed as a sole prop, SE tax is applied to every dollar of net self-employment income reported on Schedule C or earned on a K-1 from a partnership.
For a lot of small business owners FICA taxes can dwarf even federal income taxes, but this tax is often overlooked as mandatory and unavoidable. The S Corp is the solution.
In an S-Corp, net income is split into a salary portion and a pass-through or net-income portion. S-Corps are pass-through entities (just like LLCs); so all income earned in the S-Corp DOES NOT pay corporate tax and any income is taxable to the individual owners in the year earned and is subject ordinary income tax rates. However, in an S-Corp SE tax is only applied to the salary, not on the net-income. This means that for every thousand dollars you classify as pass-thru income, you save $150 in taxes!
Other benefits of an S Corp include asset protection, the ability contribute most efficiently to a 401k, build corporate credit, and also have less chance of an audit. That’s right! Estimates are that S Corps are 15x less likely to get audited than a LLC/Sole Proprietor, even though they save more in taxes!
So, why not classify all the income as dividends and take no salary? Because the IRS requires S Corps to pay owners a reasonable salary. For our recommendation with a ‘matrix’ on how much to pay yourself in a salary in an S Corp see “Dial in Your S Corp Strategy Before Year-End.”
Here are the 5 Factors that might make you a likely candidate for an S Corp:
- Do you have income subject to Self-Employment tax?
The first questions we ask clients to determine whether or not they need an S Corp is to understand if they have income subject to SE tax. Self-employment income is often referred to as ‘ordinary income’ derived from services or sale of product. It’s not income from a W-2. Examples of this type of income would be that of a realtor, broker, dentist, doctor, plumber, electrician, internet marketer, contractor, hair stylist, chiropractor, attorney, cpa, restaurant owner, manufacturer, import/exporter, real estate flipper, insurance agent, multi-level marketer, financial advisor, consultant, or anyone getting a 1099 Misc for self employment income. Passive income IS NOT subject to SE tax. Passive income is rental income, interest, dividends, capital gain, etc.
- Are there restrictions on me operating as an S-Corp in my industry?
This question inevitably comes up in locales where licensing is required for your profession. Brokers, realtors, insurance agents, doctors, lawyers, and contractors all need to check with their local licensing boards to make sure they can operate inside an S-Corp with their license. The answer is usually yes, but some jurisdictions will require the license to be held by the S-Corp or will require the business owner to jump through hoops to make this work. In one recent case, a client told me it was going to cost him over $5,000 to switch his licenses over to the S-Corp and could take months to complete. If there are going to be significant hurdles to establishing your S-Corp, you will want to asses the ultimate tax savings and whether the benefit of the S-Corp outweighs the cost before making that decision.
3. How much income do I need before an S-Corp makes sense?
This is a critical question because a business owner doesn’t need or want to incur the cost of an S Corp unless the tax savings exceeds the cost. We have generally advised our clients that the break-even point is approximately 40k in net income. Otherwise stated, if your business is making net ordinary income subject to SE tax of 40k or more, than you are a candidate for an S Corp. The reason why we feel this is the ‘break even’ point, is because of the salary/net-income allocation. We are careful and cautious to make sure payroll allocations are tailored to each business owner and their situation, but oftentimes there can be 2-3k in savings at this threshold. Again, meet with an advisor that truly understands this strategy and is willing to be cautiously aggressive.
4. How will this affect my 199-A deduction?
The 199-A deduction is a product of the Tax Cuts and Jobs Act and gives small businesses an automatic 20% deduction on all pass-through income. The deduction can be subject to a phase-out calculation for professional service business owners with AGI over $157,500 for single filers and $315,000 for joint filers. There is also another calculation that kicks in for non-professionals when they hit similar income levels. Bottom line, this is a wonderful deduction that is not inhibited by the S Corp, but actually enhanced with the strategy of the S Corp. A qualified tax advisor will help it’s business owner clients to find a balance between salary and net-income to minimize SE tax and maximize the 199A deduction. It’s a huge opportunity for planning!
- How much will an S-Corp cost me?
First, you have setup costs. This can range from $200 to $1,000 depending on the amount of consultation, support and documentation provided by the law firm performing the service. We urge you to be cautious in this process. It IS NOT simply a ‘filing of articles’. There are multiple documents that need to be included. Also, the consulting and support is critical for a business owner new to the S Corp and need to understand the maintenance procedures. We charge either $400 or $800, plus filing fee, for an S Corp in any State in the Country.
Next, you have the ongoing maintenance and the quarterly and annual tax filings. With an S-Corp you will be paying yourself a salary, so even if you don’t have other employees you will have to do payroll and file quarterly payroll reports with the IRS. The S-Corp also must file its own year-end tax return and issue you a W-2. These annual costs could range from $1500-$2000 depending on your situation.
This is why the ‘savings’ for an S Corp owner needs to be more than $2,000 before an S Corp makes ‘financial’ sense in the first place. Although the other reasons of asset protection, corporate credit and audit risk reduction still may all make sense, it’s important to understand the financial situation before pulling the trigger.
In summary, I am convinced after over 20 years of experience helping small business owners and our office supporting thousands of business owners, the S Corporation is ultimately the best entity for an operational business owner in the long run. Don’t under estimate the power of the S Corp and get a second opinion if anyone says an S Corp isn’t the best fit. Ironically, we see more people avoiding the S Corp and being talked out of it by an uneducated advisor, rather than prematurely setting up an S Corp.
The attorneys in our office are all capable of helping you with this decision based on these factors and more. The cost of a consultation is much less than the cost of making a mistake and filing for the wrong entity!
[Special Co-Author Deven Munns. A lawyer at Kyler Kohler Ostermiller & Sorensen, LLP working out of the Idaho office…Deven assists clients all over the country in tax, business, estate and asset protection matters. For more information visit www.kkoslawyers.com]
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.