An S-Corporation is a business entity commonly set up to save on taxes. In short, it’s an entity that most small business owners should use for the best possible tax benefits.
Business owners often ask if an S-Corporation is their best option. To properly answer this question, it’s important to understand the different types of business entitles. Specifically, the difference between S-Corporations and LLCs. Choosing the wrong option can cost up to thousands of dollars in taxes.
Don’t rely solely on your tax advisor to answer this question for you. Surprisingly, tax professionals often miss the mark when it comes to corporation elections. As a business owner, it is important to be properly informed so you can make the best possible decisions
Understanding the S-Corporation
LLC (Limited Liability Company) Taxed as an S-Corporation
In the eyes of the IRS, an LLC ‘taxed as an S-Corp’ is the same thing as a standard S-Corporation set up as an ‘Inc’. S-Corps and LLCs are taxed the same way.
When you convert to an S-Corporation (with a properly filed IRS Form 2553), your business name will not change. You will still have the acronym ‘LLC’ at the end of your company name. Don’t worry; this will not cause any issues with your tax filing.
Business owners may begin their business as an LLC entity, and ‘convert’ or ‘elect’ to an S-Corporation when the time is right. Until the ‘election is made, the LLCs are taxed as sole proprietorships or partnerships.
LLCs do not save business owners on their taxes. This is why it’s desirable to convert to an S-Corporation.
Benefits of an S-Corporation
The main benefit of an S-Corporation is to honestly and ethically save on Self-Employment Tax (SE Tax).
SE (Self-Employment) tax, also referred to as FICA, consists of Medicare and Social Security taxes, which total 15.3 percent of your bottom line.
In a sole proprietorship or an LLC taxed as a sole proprietorship, 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 small business owners, FICA taxes can dwarf even federal income taxes. People overlook this tax as mandatory and unavoidable. The S-Corporation is the solution.
In an S-Corporation, net income is split into salary and pass-through or net-income portions. They are pass-through entities (just like LLCs).
This means income earned is NOT subject to corporate tax. SE tax only applies to the salary, not to the net income. So, for every thousand dollars you classify as pass-thru income, you could save $150 in taxes. a
Other benefits of an S-Corporation include:
- Asset protection
- Ability to contribute costs effectively to a Solo 401k
- Ability to build corporate credit
- Decreased chance of audit (S-Corps are 15 times less likely to be audited than LLCS)
Note, that you cannot classify all income as dividends to avoid SE tax. The IRS requires that S-Corps pay owners a reasonable salary.
When to Use an S-Corp
Consider the following five factors to determine if you’re a likely candidate for an S-Corporation.
1. Do you have Income Subject to Self-Employment Tax?
These are the first questions asked when determining if you need an S-Corporation.
Self-employment income is often referred to as ‘ordinary income’ derived from services or the sale of products. Ordinary income IS NOT income from a W-2.
The below are common examples of occupations where income is classified as ‘ordinary income.’
- Realtor
- Broker
- Dentist
- Doctor
- Plumber
- Electrician
- Internet marketer
- Importer/exporter
- Insurance agent
- Multi-level marketer
- Financial advisor
- Consultant
- Contractor
- Hair stylist
- Chiropractor
- Attorney
- CPA
- Restaurant owner
- Manufacturer
- Any occupation receiving a 1099 Misc. For SE Income
If you do not have income subject to SE tax, you do not need an S-Corporation.
Passive income IS NOT subject to SE tax. Passive income is rental income, interest, dividends, capital gain, etc.
2. Are There Restrictions on Operating as an S-Corporation 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-Corporation with their license.
Some jurisdictions require the license to be held by the S-Corporation. This can lead to complications for the business owner.
In one recent case, a reported it would cost over $5,000 to switch his licenses over to the S-Corporation and could take months to complete.
When deciding whether to set up an S-Corporation, compare any potential hurdles with tax savings, to ensure the benefits outweigh the costs.
3. How much Income do I need Before an S-Corporation Makes Sense?
Be sure the tax savings exceed the cost of setting up an S-Corporation. Generally, we advise our clients that the break-even threshold is $40k in net income.
If your business is making net ordinary income subject to SE tax of $40k or more, you are a candidate for an S-Corporation.
Business Corp owners at this threshold often receive up to $2,000-$3,000 in tax savings.
Meet with a trusted advisor who understands this strategy and is willing to be cautiously aggressive. To meet with a real tax attorney about whether an S-Corporation is right for you, visit KKOS Lawyers.
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 percent deduction on all pass-through income. The deduction can be subject to a phase-out calculation for professional service business owners with AGI (adjusted gross income) over $157,500 for single filers and $315,000 for joint filers.
In short, this is a wonderful deduction that is enhanced, not inhibited, by the S-Corporation. A qualified tax advisor will help its business owner clients to find a balance between salary and net income to minimize SE tax and maximize the 199-A deduction. It’s a huge opportunity for planning!
How much is it to Set up an S Corp?
Set up costs 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, as multiple documents must be included. It IS NOT simply a ‘filing of articles’.
Next, you must pay maintenance and annual tax filings. You’ll also need to complete quarterly payroll reports with the IRS, even if you are the only person on the payroll. Remember, as an S-Corp, you will be paying yourself a salary.
Annual maintenance and filing costs range from $1,500 to $2,000, depending on your situation. This is why it is important the tax savings of an S-Corporation exceed at least $2,000. Otherwise, the tax benefits of setting up an S-Corp may not outweigh the setup an annual maintenance cost.
At Mark Kohler CPA Attorneys, we charge either $400 or $800, plus filing fee, to set up an S-Corporation in any state in the country.
Conclusion
Get a Consultation or 2nd Opinion
After 20 years of personal and in-office experience helping and supporting thousands of business owners, I am convinced the S-Corporation is ultimately the best entity for an operational business owner in the long run.
Don’t underestimate the power of the S-Corporation. Make sure to get a second opinion if anyone says it isn’t the best match.
Ironically, more people are being talked out of S-Corporations by uneducated advisors, rather than prematurely setting up an S-Corporation.
The attorneys in our office can help you with this decision based on these factors and more. All things considered, the cost of a consultation is much less than the cost of making a mistake and filing for the wrong business entity!
FAQs
See below for some additional commonly asked questions on S-Corps and how to set one up.
How Much Does It Cost to Convert an LLC to an S-Corp?
To change an LLC to an S-Corp, you’ll need to fill out IRS form 2553. The form itself is free to complete, however fees may be required after you file. For example, if you plan to alter your fiscal year you may be charged up to $6,200 in fees.
Should I use an S-Corp or an LLC for a Consulting Business?
This depends. Consider the five questions listed above, specifically, how much you earn. If you’re earning SE income, and your gross income totals over $40,000, an S-Corporation may be a good option. Consultants should also consider the licensing restrictions of their business, as in some cases setting up an S-Corp may lead to licensing complications.
An LLC may be the better option if you’re looking for less paperwork or flexible management within your consulting business.
How Do I Set up an S-Corp?
Once you’ve determined you are eligible, there are several steps to setting up an S-Corp. You’ll need to file an Article of Incorporation and pay any necessary fees. After this, you must file form 2553.
Once your S-Corp has been formed, be sure to keep up with the annual maintenance filing costs and requirements.
What is the 40-60 Rule for S-Corp Salary?
The 40-60 rule is an easy way for self-employed business owners to determine their reasonable salary. 60 percent of their business income should be designated as their salary, and 40 percent designated as distributions.
