We continue our series on business entity selection with a comparison of operating a business as a sole proprietor/LLC versus an S-Corporation. As a reminder from our previous post, an LLC does not provide any extra tax deductions or benefits that operating as a sole proprietor does, and from a tax perspective the two are identical in the eyes of the IRS. With that out of the way, we can get on to the discussion of when it might make sense to convert your sole proprietor to an S-Corporation, the factors to consider in analyzing that decision, and the pitfalls and things to be informed of before making the “S” election.
Electing to have your business taxed as an S-corporation is often a sensible decision if the numbers line up, however it is not always the right answer for every business. As an entrepreneur, it is critical to make the right decision at the right time on how to structure your business, and while you do not have a crystal ball, there are critical factors that you can consider before you even launch that can help you make that decision.
Taxability of LLC vs S-Corp
- Both an LLC and an S-corporation are taxed as ‘pass through’ entities, meaning the income of the business flows through to the owner’s personal tax returns, avoiding double taxation. However, the key distinction between an S-corporation and LLC is that an owner of an LLC is treated as self-employed whereas the owner of an S-corporation is treated as an employee. This distinction results in the potential for significant savings in the form of self-employment taxes.
- An owner of an LLC is subject to self-employment tax on their entire net business income, whereas an owner of an S-corporation's net business income is not subject to self-employment tax. This is because, as we mentioned before, the owner is treated as an employee, therefore the corresponding employment taxes are paid by the business based on the owner’s salary.
- The net effect of all of this is that you are saving approximately 14-15% on self-employment taxes for every dollar of net business income that is left over after paying yourself a salary.
- The logical next thought for many would be, well then, I will not pay myself any salary, or I’ll just pay myself a small amount and rake in the tax savings. While great in theory, the IRS has targeted this type of arrangement and enforces a concept of “reasonable compensation” to help combat this and ensure the Treasury does not lose out on its share of employment taxes.
- Reasonable compensation is not defined by a set dollar minimum, or percentage, but rather is defined as an amount that would ordinarily be paid for like services by like enterprises under like circumstances. This topic is worth its own separate post and we will delve into this in a future segment, as it is a highly controversial topic and as one can infer, often judgmental analysis that could result in significant tax exposures to S-corporation owners.
- Here is an illustration of the potential tax savings of a business that’s earning $150,000, where a reasonable salary of the operator (e.g., general manager) is determined to be $75,000.
- As an LLC or sole proprietor, the entire $150,000 would be subject to self-employment taxes, whereas the S-Corporation owner splits the $150,000 as $75,000 of salary and $75,000 of net income. The $75,000 of net income is not subject to self-employment taxes, but the $75,000 of salary is subject to employment taxes inside the S-corporation. This results in almost $10,000 of employment tax savings. This savings is partially offset by differences in the personal income tax (due to the qualified business income deduction), however you can see that the total net tax savings is just over $6,000.
- This is not the whole story, however. There are additional costs associated with operating as an S-corporation that must be taken into account, including set-up costs for making an S-election, filing an additional corporate return, and setting up a payroll processor (e.g., ADP, Gusto, etc.) to handle the additional payroll tax filings that are required. As you can imagine, these costs do add up, and depending on the complexity of your business, could total up to several thousand dollars per year.
- When the tax savings of operating an S-corporation outweighs these costs, it is generally beneficial to make such an election, however you should be taking into account the qualitative factors as well.
Additional S-Corp Considerations
Here are some of the important factors that should play into your decision of whether an S-corporation is right for your business:
- Additional Income Tax and Payroll Filing
- As mentioned above, there are requirements to file additional income tax and payroll tax filings when you are taxed as an S-Corp. In addition to the professional fees required to handle those obligations, there is the administrative burden and ultimate responsibility on you as the owner to ensure these filings are completed. In other words, there is more administrative burden to worry about.
- Limitations on Ownership and Equity Management
- There are rules on who can be the owner of an S-corporation, and you can only have one class of stock, which could become limiting factors upon trying to raise capital, offer equity compensation to employees, or finding potential buyers as part of an exit strategy.
- Further, any distributions of accumulated earnings must be made proportionately to all shareholders based on their ownership interest, LLCs are much more flexible in this capacity.
When S-Corps might not make sense
To see the example through, you can probably guess that it does not make sense to elect S-Corp status when the numbers don’t line up, and that could be the case for a number of reasons.
- Start-up loss years – your business may not turn a profit in its initial year(s) of operation. The primary benefit of an S-corporation is in savings of the self-employment taxes, and a business that’s losing money has no net income or earnings on which you can pay yourself as the owner, therefore there’s no savings to being an S-corporation. In fact you would just be further exasperating the losses in the form of professional fees for the additional payroll and income tax filings.
- Pro-Tip – make an S-election for the first year you plan to turn a sizable profit.
- Real Estate – we can hardly think of a scenario where it ever makes sense to hold real-estate inside of an S-corporation rather than just a plain old LLC that’s taxed as a partnership or sole proprietorship. We will have an upcoming post that gets more in depth on this topic, and how it ties into pro tax strategy for how to structure real estate holdings to maximize tax deferrals and truly help build generational wealth.
If you're a business owner in the New York Metro Area and need help making the best decisions for your business, request a consultation with our experienced accountants today. We look forward to providing you service.