If you are a business owner or entrepreneur, one of the first things that you perhaps did was elect to establish a Limited Liability Corporation (LLC). LLCs can be a significant upgrade from electing to operate as a sole proprietorship. This allows you a degree of asset protection and allows you to establish a business checking account and business credit. However, LLCs alone provide 0 tax benefits. As a business owner, you are on the hook for Self-Employment Tax which is 15.3% PLUS Federal and State taxes. With that being said, it is not uncommon for people to simply stick with a simple single-member or multi-member LLC even as their business generates significant positive net revenue. If this is you, listen up – filing an S Corp election can be a way for you can save thousands in taxes.
What Is an S Corporation?
An S Corporation, or S Corp, is very simply a tax election. So, you aren’t blowing up your LLC by making the election. You are very simply opting for a different tax election for your business. Once you opt to be taxed as an S Corp, profits and losses pass through to shareholders in the form of a K1. You can be the only shareholder or you can have multiple shareholders, but you can’t have more than 100. In addition to electing to be taxed as an S Corp, you can now elect to receive a salary (W-2 Income) from your business. The salary you draw and Pass-Through Income are taxed differently, which is where the savings opportunities with an S Corporation come into play.
Tax Benefits of an S Corp
Why an S Corp election can be a powerful way to reduce your business tax liability is that self-employment tax only applies to the salary you draw. Here is an example:
In the above example, you saved $6,120 in taxes. We did not factor in Federal and State taxes. However, we know what money will be subject to it. For the standard LLC, the net income of $70,000 is subject to Federal and State taxes. For the S-Corp, the Pass-through Income and W2 Income are both subject to Federal and State taxes.
Potential Disadvantages of S Corps
If you are reading this and are excited about setting up an S Corp, take a step back and think about some of the disadvantages of doing so:
- Reduced Social Security Benefits – Because the strategy relies on you reducing your contributions to Social Security, this can potentially reduce your future benefits. At MDRN Wealth, part of our planning process can evaluate what reduced Social Security benefits would look like and how they impact your financial plan if this is a concern.
- Payroll Costs – Because you are paying yourself a formal W-2 salary, you will need to properly report it and track this. This means likely paying for payroll software to keep track of your salary.
- Reporting Costs – You will need to pay additional costs for the tax forms needed to file your taxes as an S Corp each year.
- Audit Risk – Your first thought when seeing how the S Corp is taxed might be, “Why don’t I just draw a small salary, so I pay as little self-employment tax as possible?” The IRS mandates that the salary you draw as an S Corp be reasonable. Generally, this means paying yourself something that is on par with other individuals in your industry. There is a balancing act between being too conservative and being too aggressive. In addition, there are implications for other tax deductions you may be eligible for based on the salary you draw. This requires planning and coordination with your wealth and tax advisory team.
Should YOU Use an S Corporation Election to Lower Business Tax Liability?
A truly comprehensive financial planner can review your business structure, cash flows, and tax elections and educate you on ways you can optimize your situation and lower your business tax liability. That type of planning is what we provide here at MDRN Wealth. Making an S Corp election can be a big decision and there are many nuances and aspects to them not discussed in this article. If you need comprehensive financial planning, please reach out or schedule some time to meet with us.
MDRN Wealth LLC does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by MDRN Wealth LLC cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.