SCFO #004: How To Save Thousands With An S-Corp And When NOT To Use One.
Read time: 2:56 minutes
In today’s issue, I’ll show you why everyone and their mother seems to be talking about S-Corporations and when an S-Corp might not be the best choice.
Yes, you read that right. In certain situations, an S-Corporation isn’t all it’s cracked up to be.
If you can understand these concepts, it’ll put you in a position to (a) save thousands in taxes and (b) avoid the costly mistake of getting too trigger-happy with an S-Corporation for that new venture of yours.
If you read this today, you’ll join a select few willing to dive into the seemingly complex topic of S-Corporations.
The good news?
Past the jargon and terminology, the fundamentals of an S-Corp are not that complicated, and by the end of this article, you’ll have a solid understanding of the basics.
Here’s everything you need to know.
What the heck is an S-Corporation?
Put simply, an S-Corporation is a tax election.
And it does nothing to change your underlying business structure, whether you’re an LLC or a Corporation.
Think of it like serving the same meal at two different table settings. The LLC table might be more informal and laid-back, while the Corporation is more sophisticated and professional, but the meal itself remains the same.
In other words, you land in the same spot from a tax perspective, whether you’re an LLC or a Corporation.
What spot is that, exactly?
A pass-through business entity that must file a separate tax return (Form 1120-S).
The business tax return (1120-S) captures the business’s income, deductions, and credits, which then are passed to the shareholder(s) of the company on a Schedule K-1, so they can include that information on their tax return (Form 1040).
What are the tax benefits of an S-Corporation?
The magic of an S-Corporation is that it allows you to separate your business profits into two buckets:
W-2 wages, and
Business profits
That in and of itself isn’t all that magical, but the true value is behind how each of those buckets is taxed.
W-2 wages are subject to both ordinary income taxes and employment taxes.
Employment taxes include social security and medicare taxes paid by the employee and matched by the employer.
As a solopreneur, you get the privilege of being responsible for both.
But the kicker for S-Corporations is that business profits are not subject to employment taxes.
This differs from how net profits from Schedule C are taxed for Single-Member LLCs or Sole Proprietorships, where all profits are subject to employment taxes.
Let’s consider an example to make this easier to understand.
Assume your business made $100,000 this year.
Under a Sole Proprietorship or Single-Member LLC, 100% of that income is subject to employment taxes.
But with an S-Corporation, you can split the $100,000 into two separate buckets like so:
W-2 Wages → $50,000
Net Profit → $50,000
What’s the benefit? Only the $50,000 is subject to employment taxes.
To compare, employment taxes look like this under either scenario:
SMLLC/Sole Proprietorship → $14,130 ($100,000 x 14.13%)
S-Corporation → $7,650
The S-corporation saves you a massive $6,480 in employment taxes!!
So let’s set up the S-Corp, right?
Often, the analysis stops there, giving a small snapshot of the big picture.
The first thing to point out with an S-Corp is that it’ll take time and effort to set up and maintain.
And there are added costs to consider before you run out and set up your S-Corp.
Here are some of the costs you can expect with an S-Corp:
Tax return preparation: now that you’re an S-Corp, you’ll need to file a separate business income tax return, Form 1120-S.
Estimated cost = $1,000
Annual reporting: you’ll have the added cost of annual reporting for your LLC or Corporation if you’re a sole proprietorship.
Estimated cost = $200
Cost to run payroll: since you are now paying yourself, you’ll need to run payroll. You can DIY payroll processing or pay someone to do it for you.
Estimated Cost → $600 (DIY)
Tax differences: with an S-Corp, you can lose benefits of the Qualified Business Income (QBI) deduction, which can impact your federal income taxes.
Estimated Cost → $850 (for the previous scenario)
Corporate maintenance: a federal requirement of an S-Corp is keeping board meeting minutes, which you pay for or DIY.
Estimated Cost → $200
Putting it all together, the total costs of an S-Corp come to $2,850.
In our scenario, that means you save $3,630 with an S-Corp. Not too shabby!
So when will an S-Corp cost me?
Before you fully understand the benefits of an S-Corp, it’s essential to know when it may not be the best fit.
Here are three considerations to keep in mind:
No profits or low profits: the cost of maintaining an S-Corp is at least $2,000+. Generally, waiting until business profit is around $50,000 is a wise decision. 🤔
State and local taxes: different tax jurisdictions can result in additional taxes. For example, California requires S corps to pay a 1.5% tax on its earnings, with a minimum of $800 per year. Yeesh! 😬
Real estate or property businesses: distributing property from an S-Corporation can trigger a taxable event since distribution is valued at fair market value (not the case for other entity structures). This can create phantom income resulting in an unexpected tax bill. 😞
Also, S-Corps have stricter requirements, such as a limit of 100 shareholders, only one class of stock, and no non-resident alien, Corporation, or partnership shareholders.
This is not an all-inclusive list but highlights some situations where an S-Corp may not be the best choice.
In summary, an S-Corp can be a tax-saving dream come true for highly profitable solopreneurs, but you’ll want to weigh the pros and cons before jumping in with both feet.
TLDR
S-Corps are a tax election, not an entity structure.
S-Corps can save taxes because you get to split business profits between W-2 wages and business profits, and only W-2 wages are subject to employment taxes.
There are costs associated with setting up and maintaining an S-Corp.
There are several situations where an S-Corp can cost you.
P.S. if you’re a solopreneur interested in keeping more of what you make on your journey to less hustle and more freedom, book a free 15-minute call today.
Stop wasting time DIY-ing and start focusing on growing. You didn’t sign up for solopreneurship only to get stuck managing your personal and business finances.
