What is an S-Corp? The Benefits of Becoming an S-Corp
Choose your fighter.
You select Kitana.
Round 1. Fight!!
It's Mortal Kombat: IRS.
Or that's what it feels like for many business owners come tax time.
Most rounds go to the IRS. You don't have the right combo to knock them out. You need the cheat code for taxes.
Now you're in luck because I've got one. The best one I know. It can save you thousands of dollars every year. Curious?
The Best Way To Lower Your Taxes
If you've been in business for a while, you may have heard of a hidden business structure called an S corporation. This isn't even a business structure at all. It's a tax status, not a legal form of organization.
The Big Benefit to S-Corps
Before we jump into the mechanics, you should know why the extra complexity is worth it.
If your business makes a lot of profit, you may be a good contender for S-Corp status. If the profit is more than what you would pay somebody else to do your job, then I recommend you look into it.
Why? Because an S-Corp will lower your self-employment taxes.
Pull out your last tax return. There's a number I want you to find. Look through the pages for a Schedule SE. If you had a profitable year, that number will be high. That amount is the self-employment taxes you paid. That's the tax we can reduce as an S-Corp.
Self-employment (SE) tax is how you pay into social security and Medicare. Since you're self-employed, you pay it twice. Once as the employee and again as the employer. The total works out to 15.3%.
I've had clients with almost no tax liability because of credits. But, that was before the SE tax, because it's added in last. You can't offset it with most credits. The clients owed thousands.
You can't get out of paying all self-employment taxes, but you can chop it way down.
That's why you choose S-Corp status. And it's not a one-time thing. This has the potential to save you thousands of dollars every single year.
How Becoming an S-Corp Can Help You Pay Fewer Taxes
Filing for S-Corp status is simple. You fill out Form 2553 and send it off to the IRS. Depending on your state, you may need to send them a form, too. As long as you file on time and are a legal resident or citizen, you're likely to be approved.
You should receive a letter from the IRS with their result within six weeks. If successful, you'll have to make a few changes to how you pay yourself and your taxes.
First, you have to pay yourself a reasonable salary. Let's break that down.
What is "reasonable?"
What is a "reasonable" salary you ask? It's what you would pay somebody to do your job.
If you're an engineer, what does an engineer usually make? If you run a coffee shop, what does a shop manager usually make? You want to take into account any specialties, years of experience, and the local job market.
You can find salary information on job search websites, like Indeed or GlassDoor. Many payroll companies have salary comparison tools too, like this one at Gusto. In the end, as long as you can prove your salary is reasonable, you should be fine. Be sure to keep copies of your support and any documents you made to come to that decision.
You said “salary”?
As in payroll. You need to pay yourself a reasonable income via a salary. As an S-Corp, you become an employee of your company. You'll receive a paycheck (woo-hoo!). And like any employee, you'll have taxes withheld.
As the employee, you'll have 7.65% withheld to pay into social security and medicare. As the business owner, you have to match that amount.
The tax savings arise from the profit left over after your salary. On this amount, you don’t pay the employee or employer's share of social security and medicare tax.
Said another way, you'll pay self-employment taxes on your salary paid via payroll. Any profit left over after the salary is not subject to self-employment taxes.
Let's go through the numbers so it’s clearer.
Your company makes $100,000 in profit. As a single member of an LLC, you'll pay self-employment taxes of 15.3% on the entire $100,000 amount. That works out to be $14,130. (I realize that is less than 15.3%, due to a related deduction.)
Now let's say you're an S-Corp, and you pay yourself a salary of $60,000 with a net profit of $40,000. You pay income taxes and self-employment taxes on the $60,000. Your total taxes due would be $9,614.
That saves you $4,515.
In both cases, as the owner/employee, you make $100,000 in personal income. The difference is as an S-Corp, you'll keep $4,515 MORE of that money after taxes.
>>> Please note that you will still owe income tax on the entire $100,000 in both situations. Self-employment taxes are separate from income taxes.
S-Corps: The Catch
As you can see from the example, S-Corps save a lot of money in taxes. But, you need to be aware of two important requirements.
1. Payroll (as you well know by now!) You need to pay your reasonable salary via payroll. You can do this via paper or hire someone to do it for you, but I'd recommend not. Instead, I recommend using a service like Gusto (full disclosure: this is an affiliate link). Gusto will handle all the tax payments, legal filings, and complicated compliance tasks. This is important because errors can come with big fines. In 2014, the IRS fined businesses more than $2,000,000,000 for mistakes. Gusto is very affordable, starting at $25 a month for S-Corp owners.
2. File an S-Corp tax return every year. (If you're a partnership, this isn't a big change as you already file a partnership return.) Instead of a Schedule C, you'll file a separate return due on March 15th. It reports the business income, expenses, and profit. At the federal level, you don't pay tax when you file this return. The income "passes through" to the owner, and they pay taxes on their personal tax returns (what you usually file). From the S-Corp return, you'll receive a form K-1 to include on your personal return. An important caveat applies if you live in a state with an income tax. They may tax your S-Corp and give you a credit on your personal return. It's their way of getting around changes to itemized deductions from the Tax Cuts and Jobs Act.
The catch is that both of those two tasks aren't free. There are costs associated with running payroll and filing another tax return. You need to take these costs into account when evaluating if it makes sense to be an S-Corp.
Your state may throw in another wrinkle. Some states, like California, charge high annual fees for being an S-Corp. This means you need more leftover profit for an S-Corp to be a smart financial move.
Does an S-Corp make financial sense for you?
The only way to find out is to run the numbers.
As a general rule, you need at least $20,000 in profit (after your salary) to break even. If you live in a state with high fees, you need even more profit before you’ll break even.
Here is a free calculator to test the numbers. You'll need to look up your net profit from last year, an estimated reasonable salary, and any state fees.
This calculator estimates how much profit you'll need before you break even. It uses your net income, a reasonable salary, and the extra costs to find how much profit you need to break even.
How to become an S-Corp:
You have two windows when you can elect S-Corp status. The first is right after you form the company through your Secretary of State. You have 75 days to make the election.
The second window is within the first 75 days of each year. The S-Corp status would take effect for that tax year – not the prior year. For most taxpayers, this election is due on March 15th.
Making the election is quick. You complete Form 2553 and send it to the IRS. Within a few weeks, they'll respond to say whether they accepted it or not. Depending on your state, you may need to notify them as well.
Right now, it's early February – you have until March 15th to file the paperwork to elect S-Corp status for 2021.
When you sign up for payroll, you're going to need to make sure you have a few state tax registrations. This is usually for tax withholdings as well as unemployment insurance. (Side note: this means if your business goes under, then you can collect unemployment.)
You can check this list for your state to see where you need to register.
It's quite a process to set up an S-Corp. Some terms don't mean what you may think and there's a lot of information to wade through. If you're interested in forming an S-Corp, but hesitate because of all the complexity, drop me a note or take this quiz. I've helped dozens of businesses with this and got it down to a science.
Knockout!!
Kitana is down. Sorry to say, but you lost the round. The IRS is good. You really can't win against them. Death and taxes. In this case, you got both.
But you put up a good fight. You fought hard, did a lot of damage, and paid as little as you had to. You paid your fair share and nothing more.