Making the S-Corporation election can be a powerful tax saving strategy. With great power comes great responsibility. Before making the S-election, a cost-benefit analysis should be run and it is important to be aware of the benefits, considerations, and drawbacks of making the S election.
“Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisors regarding your specific situation.”
What is an S Corporation?
This article will only discuss LLCs that choose to be taxed as an S Corporation. An S-Corporation is a corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Since the shareholders report these numbers on their personal tax returns, the S-Corporation can avoid the double taxation on corporate income.
To qualify for S-Corporation status, the corporation must meet the following requirements:
Be a domestic corporation
Have shareholders that are individuals, certain trusts, and estates (partnerships, corporations, or non-resident alien shareholders are not allowed)
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation such as certain financial institutions, insurance companies, and domestic international sales corporations.
For some LLC owners, making the S election can provide large tax savings, particularly if the LLC earns “active income” and the self-employment tax generated from income allocated to the owner(s) is high.
Advantages: an LLC Being Taxed as an S-Corporation
It is important to understand that an LLC is a type of business entity, while an S Corporation is a tax classification. The owner(s) would first create an LLC, then do a cost-benefit analysis to determine if an S-Corporation is appropriate, and then make the election. Therefore, when an LLC makes the S-Corporation election, the owner(s) of the business still enjoy protection of their personal assets from any corporate liabilities.
S-Corporations are very similar to partnerships in how they are taxed since they also pass their income, losses, deductions, and credits through to the owner(s) using a Form K-1. However, there is one major difference for businesses that earn “active income.”
Active income, defined as income earned from a job or business venture that requires your active participation, is subject to the 15.3% self-employment tax. A traditional W-2 employee pays this tax too, but it looks different for them. They will withhold 7.65% from their paycheck for social security and medicare, and their employer will pay the other 7.65%.
If the LLC elects to be taxed as a S-Corporation, owners must be paid wages as an employee. Therefore, only the wages paid to the owner/employee are subject to Social Security and Medicare taxes. Any income remaining after wages are paid to the owner/employee are not subject to self-employment tax like they would be under traditional LLC taxation.
Considerations: How to determine a reasonable salary for the Owner/Employee?
Since the only earnings subject to self-employment tax is the amount you decide to pay yourself as the employee/owner, there is an incentive to pay yourself a very low employee salary and issue a distribution for any other funds you plan to take out of the business. While this might be great in theory to achieve greater tax savings, the IRS looks closely at salaries paid to owner/employees and requires S-Corporations to pay a “reasonable salary.” If it is determined that the amount the owner/employee pays themselves as wages is inappropriate, the IRS has the authority to reclassify distributions to wages, resulting in back taxes, interest, and penalties.
When determining the amount to pay the Owner/Employee for an S-Corporation, the IRS looks at the following factors:
What comparable businesses pay for similar services
Training & Experience
Duties & Responsibilities
Time & effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
Compensation agreements
The use of a formula to determine compensation
Justifying a reasonable salary does not require the use of all of these factors, and no one factor is more important than the others. To properly save money on taxes from earning active income, it is important that these factors are being considered when determining your “reasonable salary.”
Drawbacks: Due Dates & Administrative Costs
To make the S-election for your LLC, IRS Form 2553 is required to be filed two months and 15 days after the start of the tax year in which you want the election take effect. Established businesses can also file any time during the preceding tax year.
It is important to be aware that S-Corporations file their own tax return, IRS Form 1120S, even if they have only one owner. The S-Corporation tax return is due on March 15, or if extended, September 15. You will need books & records for your CPA to properly file this return. You should also be aware that some states tax S-Corporations differently than LLCs, which can cause additional state tax.
Lastly, you will need a payroll provider to start paying your owner/employee. A good payroll provider can offer direct deposit to your employees and should handle the federal, state, and local payments and filings required. Depending on your salary and state, there will be annual, quarterly, monthly, and even bi-weekly due dates for filings and payments that your payroll provider will be responsible for handling.
Make sure to budget for the costs of an extra tax return, professional bookkeeping services, payroll fees, payroll taxes, withholding taxes, and potential additional state taxes. All of these added costs and administrative responsibilities should be included in your cost/benefit analysis of making the S-Corporation election.
Simple Example:
Single business owner
Share of Business Profit before Wages: $500,000
Wages paid to Owner/Employee: $125,000
Total taxes under regular conditions (LLC taxed as a disregarded entity or pass-through partnership): $172,662
Total taxes after making the S-corporation election: $121,833
Tax Savings: $50,829
Estimated Additional Administrative Costs:
Payroll: $100/mo = $1,200
S-Corporation Tax Return + Bookkeeping = $300/mo = $3,600
FUTA tax = $42
Administrative Costs: $4,842
TOTAL SAVINGS: $45,987
ROI: 1,050%
Rental Real Estate Entities Beware!
As mentioned above, S-Corporations can be great if you have an active trade or business (flipping properties, earning commissions as a real estate agent or wholesaler, or running a professional practice) however if you own a rental real estate business, then you may want to avoid this topic for that entity.
Rental real estate is not subject to the employment taxes that make this election such an attractive option to LLC owners. Therefore, owners who make the S election for rental real estate add additional unnecessary costs and employment taxes with no tax benefit. Other drawbacks include additional loss limitations and less flexibility to transfer appreciated real estate.
If you want to buy an office building for your active trade or business, it might be best to open a new LLC and have your S-Corporation pay rent to the new LLC to avoid these drawbacks.
It is wise to consult with your CPA before coming to a conclusion on whether the S-election is right for your business and what your reasonable salary should be.
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