Before I get started, I just want to let you know that we did an entire series on S Corporations on both our Blog and Small Business Tax Savings Podcast, so if you want to dig deeper from what we discuss today, check that out.
Everything You Need To Know About S Corporations
We also have a very in depth deep dive into S Corporations as a Module in our Tax Minimization Program. If you are a member you will want to go through that entire module, if you are not a member now is a great time to join!
With that being said, I always like to do a refresh on S Corps every year so that is what we are talking about here!
What Is An S Corporation?
An S Corporation is simply a tax election. It is not a separate entity. You need to have an LLC or a C Corporation already setup and then you simply elect for that entity to be taxed as an S Corporation.
As part of our Tax Minimization Program we go through the exact steps you need to take to elect S Corp status so you are able to do it all on your own!
Why Would Someone Want To Be An S Corporation?
Great question! The number one reason we see small businesses electing S Corp status is to save on self employment taxes.
The majority of businesses we see are setup as an LLC and thus paying self employment taxes on the profits of their business. Lets go through a quick example to illustrate:
As a Sole Prop or Single Member LLC (SMLLC) you pay your normal income tax rate on the income of your business as well as self employment taxes. Self employment tax is broken into two separate pieces, Social Security and Medicare. Social Security is 12.4% on your first $147,000 (2022) of business income. Medicare is 2.9% on your total business income. The total combined is 15.3%.
In this example, if your business profited $80,000 you would have $11,304 in self employment taxes and that would be over and above your normal income tax rate.
An S Corp is a strategy that may work to help reduce the amount of self employment taxes. As part of our Tax Minimization Program we have a Payroll Tax Savings Calculator that you can use to enter your specific data to see what your savings would be.
How Is An S Corp Taxed?
As an S Corporation there is no federal income tax at the corporate level instead the profit from the S Corp flows through to your personal 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.
Salary? Yes, with an S Corp you must be a W2 employee of the company and pay yourself a reasonable salary which you get hit with self employment taxes on.
However, any profit from the business over and above your salary you can take as a dividend and thus avoid self employment tax on that portion.
Lets look at a diagram:
Essentially we are taking the profit of your business and splitting it into two pieces, a salary and dividend.
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.
What Is The Difference In Taxes Between A Sole Proprietorship and S Corp?
Lets take what we discussed above and do a side by side example to show the tax differences between the two.
In this example with $80,000 of profit if you were setup as a sole proprietor or disregarded entity you would pay $11,304 in self employment taxes. This in addition to your normal income tax rate.
However, with an S Corp we only pay self employment taxes on our payroll. In this example we assumed a reasonable salary of $36,000 which would amount to $5,928 in payroll taxes.
As you can see by simply electing S Corp status you would see tax savings of $5,376. These would be savings you would see each and every year!
You may be wondering, if I took a salary of only $36,000 what happened to the other $44,000. You would take that as a dividend (similar to an owners draws) and it would not be subject to self employment taxes. This is where the tax savings occurs.
Of course these savings are self employment tax savings, you would still owe your normal income tax rate as well, in both scenarios.
As mentioned above as part of our Tax Minimization Program we have a Payroll Tax Savings Calculator that you can use to enter your specific data to see what your savings would be.
Is There Any Disadvantages To An S Corp?
Good thing you asked. Yes, there are some disadvantages to an S Corp and most of these really just come down to a little more compliance and complexity.
- Separate Business Tax Return
- An S Corporation requires its own separate tax return. If you are use to filing as a sole proprietor you know that it gets recorded on your personal tax return with a Schedule C. With an S Corp you have a business tax return (Form 1120S) which will have a K1 on it that is used to report the profit from the S Corp onto your personal return.
- This separate business tax return is typically going to result in added tax preparation fees.
- You will also need a full set of financials (Income Statement + Balance Sheet). Now I don’t look at this as a bad thing as I think every business should have complete financials but it is worth mentioning that if you elect S Corp status you need to formalize your bookkeeping a bit so you can create financials.
- W2 Payroll Required
- As discussed, with an S Corp you are required to pay yourself a reasonable salary which is regular W2 payroll. This means you need to withhold taxes, file tax forms, submit W2s and all of that fun stuff.
- This required W2 payroll is going to result in need to have a payroll service which will be added fees.
There are a few other disadvantages but the two mentioned above are the most common that will affect every S Corp.
In our Blog Post and Podcast Episode next week we will be digging into when it makes sense to elect S Corp status vs when it does not.
Can You Give a Quick Summary of S Corporations?
- An S Corp is simply a tax election. It is not a separate entity. You first need to be an LLC or C Corporation and then you elect to be taxed as an S Corp. You still remain the same company, it is just a tax election.
- The number one reason to elect S Corp status is to minimization self employment taxes.
- As a Sole Proprietor or Single Member LLC you get hit with self employment taxes on 100% of your income.
- With an S Corp you need to take a reasonable salary which will get hit with self employment taxes but any income over and above your reasonable salary you avoid self employment taxes on.
- Roughly stating, a business profiting $80,000 per year will save over $5,000 in taxes per year by electing to be taxed as an S Corp vs Single Member LLC (disregarded entity).
- The two biggest downsides to an S Corp are that you need to file a separate business tax return and you need to bring on a payroll company to handle W2 payroll to yourself as the owner.
- We did a full series on S Corporations which you can find here.
- We do a very through deep dive on S Corporation in our Tax Minimization Program where we go through:
- S Corporation Strategy
- Payroll Tax Savings Calculator – Run scenarios of your specific situation to see what savings you would have.
- S Corporation Disadvantages
- Deciding If An S Corp Is Right For You
- Exact Steps on How To Elect S Corp Status
- How to Determine a Reasonable Salary
- Reasonable Salary Worksheet
- How to Setup Payroll for An S Corp
- Steps You Need to Take After Electing S Corp Status
- and so much more…
Again, next week we will be talking about when an S Corp may make sense to you vs when it may not. You will want to check that out to ensure you are making the right decision!