To elect, or not to elect, S corporation status…
This is a question that many small business owners ask themselves when their business starts growing. Contrary to what is discussed on social media, electing S corporation status for federal tax purposes does not always result in a net benefit to the business. When evaluating whether it’s time to make this election, there are several considerations for small businesses.
First, it’s important to remember that your limited liability company (LLC) is not an S corporation. An LLC is a state designated legal entity that provides certain asset and legal protection for its owner(s). If an LLC is owned by one individual, it is considered a disregard entity by the IRS. Disregarded entities do not have to file a separate tax return. The individual owner can report its income and expenses from its business on Schedule C that gets attached to the personal return. The net profit from a Schedule C is subject to self-employment taxes at 15.3% less the tax benefit received from a deduction the owner gets on their personal return.
In contrast, S corporation status is a tax classification provided in the Internal Revenue Code that requires an election and separate business return to be filed. S Corporation profits are not subject to the self-employment taxes. Rather, the owner must pay themselves a reasonable wage, which would be subject to payroll taxes (the same 15.3%). This is where the benefit comes into play. The profit after the owner’s wages would not be subject to self-employment or payroll taxes. Profitability is the single most important factor in deciding if an S corporation election should be made (assuming the size and owner requirements are met).
To make an informed decision about your S corporation election, consider the following factors:
1) Profitability:
Generally, profits from the business should be at least between $50,000 to $100,000 for there to be a significant net benefit to the business. Simply comparing the savings in self-employment taxes does not provide the full picture. There are other costs and deductions that need to be considered when performing the analysis. Once the business is an S corporation, payroll will have to be processed and a separate business return filed, adding additional expenses upwards of $2,000.
2) Anticipated future income:
Consider the projected income for the upcoming year and beyond. If you expect a substantial increase in profits, as profit begins to approach to the lower end of the election range, it may be a good time to explore S corporation status.
3) Reasonable Salary:
It's essential to determine what constitutes a reasonable salary for your role in the business. Paying yourself too low a salary could attract IRS scrutiny, while paying too high a salary could diminish some of the tax advantages of S corporation status.
4) Administrative burden:
Payroll requirements for S corporation owners and the separate business return require additional effort from the business owner to adhere to more stringent record-keeping and corporate formalities. Bookkeeping can be outsourced but obviously at a cost further reducing the benefit of being an S corporation.
5) State considerations:
Some states have taxes associated with being an S corporation. But some states also allow a pass-through entity election that would allow the individual owner to pay their state income tax obligation from the S corporation, potentially allowing for a greater tax benefit for taxpayers that itemize deductions on their personal return.
Ultimately, the timing of your S Corporation election should align with your business's financial goals and your understanding of the tax implications.
Consulting with a tax professional or CPA is essential to making an informed decision that is tailored to your specific circumstances. Roberts CPA can help you assess when the timing is right and guide you through the process of making the election.