When to use an S-Corporation?

 

Don’t underestimate the power of an S Corp, and always get a second opinion if someone says it’s not the best choice. An S Corporation can save you money on taxes, and many small business owners should consider it. People often ask if an S Corporation is right for their business. It’s important to know the basic differences between an S Corporation and an LLC.

Some advisors give bad advice that can cost small business owners thousands of dollars. Remember, you are in charge! Make sure your advisors understand the basics and give you the right advice.

LLC Taxed as an S-Corporation

An LLC taxed as an S Corp is the same as a standard S-Corporation in the eyes of the IRS.

When you convert to an S-Corporation with IRS Form 2553, your company name will still end with “LLC,” and that’s fine. Business owners often start with an LLC and switch to an S Corporation later to save on taxes. Until then, LLCs are taxed as sole proprietorships or partnerships.

Remember, an LLC alone doesn’t save you any taxes! That’s why converting to an S Corporation is important.

Benefits of an S-Corporation

The main benefit of an S Corporation is saving on Self-Employment Tax (SE Tax), which includes Medicare and Social Security taxes, totaling 15.3% of your income. In a sole proprietorship or LLC taxed as a sole proprietorship, SE tax applies to every dollar of net income.

For small business owners, FICA taxes can be higher than federal income taxes. Many people think this tax is unavoidable, but an S Corporation offers a solution. In an S Corporation, income is split into salary and pass-through portions. While all income is taxed at individual rates, only the salary portion is subject to SE tax. This means you save $150 in taxes for every $1,000 classified as pass-through income.

Other benefits include:

  • Asset protection
  • Ability to contribute costs effectively to a Solo 401k
  • Building of corporate credit
  • Decreased chance of an audit.

That’s right! Estimates are that S-Corps are 15x less likely to receive an audit than a LLC/Sole proprietor, even though they save more in taxes!

Here are the 5 Factors that might make you a likely candidate:

1. Do you have Income Subject to Self-Employment Tax?

This is to determine whether or not they 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.

2. Are There Restrictions on Operating as an S-Corporation in my Industry?

The answer is usually yes, but some places require the license to be held by the S Corporation. This can involve significant costs and time. For example, one client faced over $5,000 in expenses and months of work to switch his licenses.

If there are major hurdles to establishing your S Corporation, weigh the potential tax savings against the costs before deciding.

3. How much Income do I need Before an S-Corporation Makes Sense?

If your business earns $40,000 or more in net income subject to SE tax, you’re a candidate for an S Corporation. This break-even point works due to the salary and net-income allocation. With careful planning, business owners can often save $2,000-$3,000 at this threshold.

4. How will this Affect my 199-A Deduction?

The 199-A deduction, a result of the Tax Cuts and Jobs Act, grants small businesses a 20% deduction on all pass-through income. For professional service business owners with AGI over $157,500 (single) or $315,000 (joint), this deduction phases out. A similar calculation applies to non-professionals at similar income levels.

This deduction is beneficial and can be optimized with an S Corporation strategy. A knowledgeable tax advisor can assist business owners in balancing salary and net income to reduce SE tax and maximize the 199-A deduction. It’s a significant opportunity for tax planning!

5. How much will an S-Corporation cost me?

Setting up an S Corporation involves initial costs typically ranging from $200 to $1,000, depending on the level of support and documentation needed from the law firm handling the process. It’s crucial not to rush through this step, as it’s more than just filing paperwork.

Ongoing maintenance includes quarterly and annual tax filings, as well as payroll responsibilities if you pay yourself a salary. Even without other employees, you’ll need to manage payroll and file quarterly reports with the IRS. Annual costs for these tasks could be between $1,500 and $2,000, depending on your specific needs.

To financially justify choosing an S Corporation, the savings should exceed $2,000. Other benefits like asset protection, building corporate credit, and reducing audit risks also play a role, but it’s essential to fully understand your financial situation before proceeding.

 

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