Business owners often don’t understand their taxes and just hope they are doing everything to keep their heads above water. Then they hear how a friend’s “S-Corp” is saving them so much in taxes. When entrepreneurs make the mindset shift from just getting by with taxes to forward-thinking tax planning, there can be opportunities to save money. One of the more popular opportunities is for LLCs to elect to be taxed as an S-Corporation (“S-Corp”) and significantly change the tax structure of the business, hopefully to save money.
How It Works
When setting up a business, many owners naturally choose the Limited Liability Company (LLC) as their entity structure of choice. Most people understand the legal benefits of an LLC, but many don’t understand the tax implications. That is partly because an LLC is designed with legal protection only, and there are no pre-determined rules for taxes. As a result, a business must pick one of the other entities for tax purposes, or let the IRS choose one for them. Usually, the IRS defaults to either a sole proprietor or partnership, depending on how many owners there are.
This is when the S-Corp comes in since an LLC can specifically elect to be taxed as a S-Corp instead of what the IRS defaults to. From a tax perspective, a S-Corp is a blend of partnership and corporation tax rules. When I explained this to a business owner last week, the natural response was “I don’t want to be a corporation, I will be taxed twice”. While the S-Corp election shares some similarities with normal corporations (“C-Corp”), there are notable differences.
Similar to a partnership, an S-Corp is still considered a pass-through entity. This means there is no federal corporate tax rate and taxes will still pass through to the owner’s personal tax return. This leads to two important points:
First, electing an S-corporation can have separate implications at the federal and state levels. Some states unanimously accept all federal S-Corp elections while others have different rules or even reject them. This is where an accountant should step in and ensure this strategy can work for you.
Second, income for owners in an S-Corp is treated differently than income in a Sole Proprietorship or Partnership. Within an S-Corp, owners working in the business are considered employees. Within a Sole Proprietorship or Partnership, owners are not considered employees. At least in Kentucky (and many other states), this means the S-Corp separates the income to the owner for their services and the income for simply owning the company.
Why It Could Save You Money
S-corporations pass through two primary types of tax: income tax and self-employment tax (SE tax). Income tax is factored off of the profits of the company and taxed at the owner’s individual tax rate. SE tax is a 15.3% tax for Social Security and Medicare, up to $168,600 in income for 2024. One of the primary motivations for electing to file as an S-Corp is to reduce the SE tax.
Because owners are treated as employees, owners of an S-Corp may be able to pay themselves a W-2 salary for their work in the business. Only the salary would be subject to SE tax, not their total “income” for the year. For example, a sole proprietor who had $100,000 in income for the year would be responsible for SE tax on all $100,000. An S-Corp owner who paid himself a $60,000 salary and paid out the remaining $40,000 as distributions would pay SE tax on only $60,000. As a result, the $40,000 difference for the 15.3% SE tax would be $6,120 less in taxes.
One of the most important aspects of this strategy is to define what a reasonable salary is. Without considering any other variables, it appears that the lowest salary would mean the lowest SE tax. In almost every situation though, the lowest salary may not be the best salary. Owners who do almost everything (from sales to operations to fulfillment) may have a reasonable salary much closer to the total profits of the company. Other owners may only contribute minimally to the business and could pay out a lower salary. It’s best to consult with a CPA to determine what is reasonable for your situation, as the IRS is very strict on properly paying wages relative to the work of the owner. Since the IRS does not have exact expectations of what is reasonable, it is very important to seek professional tax advice here.
When It Is Not a Good Idea
Like any financial strategy, there are benefits and drawbacks that are critical to understand. Depending on the specific circumstance, an S-Corp can save an owner thousands of dollars, but there is no such thing as a free lunch. Changing the entire tax structure of your company can impact many other parts of your business. The IRS has set many rules and regulations for S-Corps to follow to stay compliant. Generally, S-corps must be less than 100 employees, must be formed in the US, must be owned by individuals (not trusts), and many other restrictions. There are different reporting requirements, they are required to file separate tax returns, and require new payroll procedures.
S-corporations also affect other areas of your tax planning. Many times, choosing the lowest possible “reasonable salary” could hurt deductions and credits already available. The Qualified Business Income Deduction can be a huge concern, since many businesses can generally deduct up to 20% of profits each year. In the example above, a $20,000 QBI deduction on $100,000 of profits with the sole proprietor is much more preferable to an $8,000 deduction on $40,000 profits with the S-corporation.
It is important to do the analysis and think through all the changes required. There is no one right answer without digging deep into the details, and understanding how the deductions, retirement contributions, payroll processes, etc. would change. S-corps can save taxes for some situations even despite the drawbacks. Saving on self-employment taxes is great but factoring the costs of new business practices as well as any potential loss in current savings can dramatically change the strategy. That is why it is so important to include professionals in your calculation and see if this strategy is right for you.
No One Likes Taxes
At the end of the day, taxes and tax planning should be focused on supporting the owner and their business. Many times, there are tax planning strategies that could save you thousands. S-corporations have the potential to reduce your self-employment taxes and put more money back into your pocket. But they also have the potential to make your business and life unnecessarily more complicated. Work with the right team to see if this works for you and focus at least from a tax perspective on what you can control today.
TC Falkner 