# S Corporation – Computing the Tax Savings

When deciding if you should elect Sub-chapter S corporation status for your company, you need to run the numbers first!

Electing to be taxed as a Subchapter S Corporation instead of as a Sole Proprietor could mean big tax savings for you as a small business owner. Notice I said could–because it’s not always the case. It’s really important to run the numbers – all the numbers – and do a comparison so you can make an informed decision.

This post is going to be a little technical. I apologize for that up front. I’m going to try to keep it in plain English though, because even if you can’t run the numbers yourself, you need to see what I’m talking about so you can discuss this with your accountant.

Here’s an example where I think choosing to be a Sub S Corporation is the right choice for a business owner: Jack Sparrow is a single, self employed pirate with net self-employment income of \$100,000. (Yes, Johnny Depp was on TV last night.)  Jack has no other income to report on his tax return.

I ran the numbers for 2014 and it shows the total tax on the 1040 return to be \$30,680. (\$16,550 for the income tax and \$14,130 for the self employment tax.)

That’s a lot of taxes!

But what if Jack were to set up a Sub Chapter S Corporation? He’d have to set himself up to receive payroll–(that’s part of the deal with an S Corporation, you have to pay yourself a salary) but the rest of his income would be taxed at his regular tax rate (they call that ordinary income) instead of at the self employment rate.

So for my example, I set Jack up with a payroll of \$40,000, his S Corp income is \$56,340 (not \$60,000 because he’s paying some payroll taxes that are deducted.) So when I run the taxes for that, I’m showing that his total tax on his 1040 is \$17,400.

Right here you’re probably going, “\$13,280 in tax savings per year? Awesome! Sign me up now!”

But it’s not that simple. Because remember, part of being an S Corporation means that you must set up a salary for yourself and pay the payroll taxes. If you don’t include the cost of those payroll taxes in your calculations, you’re not giving yourself a true comparison of the total tax cost.

For Jack’s example, we set up a payroll for \$40,000. From his \$40,000, Jack will have \$3,060 withheld as his employee share of FICA-that’s the Social Security and Medicare tax that gets withheld from everyone’s wages.  Also, remember when I said his S Corp income was \$56,340 instead of \$60,000? That’s because as an employer, Jack also had to pay an additional \$3,060 for the employer’s share of FICA, and I added another \$600 for state and federal unemployment taxes. The unemployment tax will vary by state but \$600 is a reasonable estimate.

When you add those payroll tax costs to the 1040 tax cost, Jack’s total S Corp taxes are now \$24,1120. That’s still a big tax savings of \$6,650! In this case, of course I would recommend that Jack go for the S Corp.

Just for fun, what if Jack were offered a pirate job as a wage earning position? All W2 income with no self-employment at \$100,000 per year? Just running the numbers straight like that,  his 1040 taxes would be \$18,341 and his FICA withholding would be \$7,650 so his total tax cost would be \$25,991 which turns out to be \$1871 more than his S Corp taxes.

Now in real life, there would be other considerations – like health insurance and other fringe benefits that might make Jack want to jump at that wage position.  But I left all of that out for this comparison.

The chart at the bottom of the post shows the numbers for Jack’s case side by side so you can see how I got to my numbers, in case you want to replicate them for yourself.

So, how do you determine if YOU should have an S Corporation instead of a sole proprietorship? You look at these numbers and it’s pretty persuasive. If you could save \$6,000 or more a year, who wouldn’t do that? But taxes have a lot of moving parts these days. Maybe you have investment income, maybe you have wages from another job. Maybe you have deductions that are allowed on a Schedule C that aren’t allowed for an S Corp. Healthcare costs can also make a difference and so can your retirement savings goals.

If you don’t run the numbers fully through a tax program, including the payroll tax costs, you could actually lose money going with an S Corp. I ran a scenario the other day – this is a real person’s actual numbers: her tax savings by converting to an S Corp–before adding in any payroll taxes, was only \$1,338. She’d spend that much in accounting fees for the payroll and additional tax return. Adding in the FICA and employer payroll taxes we send her to the loss column. I never would have known that had I not sat down and ran the numbers based on her whole situation.

While that taxpayer’s situation was unique, your situation is also unique to you. Before electing to be an S Corporation, make sure you have all the facts and run all the numbers.  You’ll be glad you did.

Here’s that chart I promised you:

Comparison of wage, vs. self-employment, vs. Sub S Corporation taxes

# How to File an Extension for Your Sub-Chapter S Corporation

Form 7004

Sub-Chapter S Corporation tax returns (1120S) are due on March 15th. Are you done yet? If not, you might need to file for an extension. Here’s how:

First, make sure you really are a Sub-S Corp. I know that sounds silly, but every year (really, every year) I run into someone who thinks they have a Sub-S Corporation and doesn’t. It’s really important not to file paperwork for an entity that you’re not. If you’re an LLC that wants to be a Sub-S and you’re filing a “Whoopsie, I forgot to do the right paperwork clause,” you can’t file an extension, you’ve got to get your stuff in by March 15th.

But if you’re already a Sub-S corporation, then you can file for an extension if you need to. What you want is Form 7004. Here’s a link to it: http://www.irs.gov/pub/irs-pdf/f7004.pdf.

It’s easiest to just file it online and be done with it. But if you don’t have access to the software, you can paper file. Here’s the official list of mailing addresses: http://www.irs.gov/file/article/0,,id=177836,00.html . Basically, if you’re east of the Mississippi you’ll mail it to:

Department of the Treasury
Internal Revenue Service
Cincinnati, OH 45999-0045

If you’re west of the Mississippi it will go to:

Ogden, UT 84201-0045

For some reason Florida and Louisiana are listed with the “west of the Mississippi states.” Anyway, Florida and Louisiana get mailed to Ogden. Also, any Sub-S with income of over \$10 million sends its extension to Ogden no matter where the business is located. (Any Sub-S with income of over \$10 million should have an accountant that can file the extension for them and you shouldn’t be reading a how-to blog about it. Seriously.)

You’ll have to check with your state to determine if you are required to file a separate extension for your state. Here in Missouri, your federal extension will serve as your state extension – you’ll just attach a copy of your Federal 7004 to your Missouri 1120S when you file it. You only need to file a MO 7004 if you have a franchise tax liability.

Why should you care about filing an extension? Money! If you don’t owe any money on your tax return, the penalty for filing late is \$195 for each month (or part of a month) that the return is late, multiplied by the number of shareholders. So let’s say you and a buddy have a Sub-S corporation and you forget about the March 15th deadline and file on April 15th instead. You’ll owe a \$390 penalty on a tax return with no balance due. That stinks. Of course, if you totally blow things off and file in August, the penalty will be \$1,560 – on a tax return with a zero balance due! See why it’s important to file that extension?

Sub S corporations generally don’t pay tax with their corporate form, but if you do owe money for some reason the penalties are even higher.

Even though extensions are fairly simple forms, you still might not want to do it yourself. This is one form that Roberg Tax Solutions can prepare for you over the phone for \$25. You’ll need your business name, address, EIN number and a credit card and we can do it while you’re on the phone with us. It’s that easy. You have no reason not to get your extension in on time.

# Estimated Taxes for Small Businesses

Photo by Shayne Kaye on Flickr.com

I’ve gotten this question twice in the past week so I thought I’d post it on my blog:

I pay my estimated taxes out of my personal account, but really I’m paying estimated taxes for my small business, shouldn’t I take the money out of my business account?

That’s a really good question, and the answer is “It depends.” If you own a C corporation, then the answer is yes. But most of the small businesses I deal with are Sole Proprietors and Sub S Corporations; if you have one of those, the answer is NO!

Here’s why Sole Proprietors and Sub S Corporation Owners should not pay their estimated taxes out of their business accounts: All of the profits from these kinds of companies are taxable to the individual that owns them. The companies themselves pay no tax, the individual owner does. Because the owner, not the company, owes the tax, the owner must pay from his personal account.

Let’s do an example: Daisy Duke owns Daisy’s Delightful Doggie Daycare (D4). It’s basically a pet-sitting business she runs out of her home. Daisy’s pretty savvy about accounting, so she maintains a separate bank account for her business and she claims every legal deduction she’s entitled to. She runs all of her business expenses through her business account.

For the quarter, Daisy has \$10,000 of income and \$6,000 of business expenses. She wants to make an estimated payment on the remaining \$4,000 of income. Daisy determined that she spends 40% of her net income on federal taxes so she’s going to send \$1600 to the IRS. This check is not written on the D4 checking account, but instead on Daisy’s personal account.

Note that Daisy runs all of the business expenses through the business account, but because the taxes are not considered to be a business expense, they can’t go in there. If Daisy were to take her kids to Chuck E. Cheese’s for pizza, she would not pay for that out of her D4 account either. Now it’s sounds crazy equating estimated tax payments with Chuck E. Cheese’s Pizza but to the IRS’s eyes, they’re the same thing—a personal expense.

So here’s the next question that people always ask: What if Daisy doesn’t have enough money in her personal checking account to pay the taxes? That’s another good question. Remember, though, that the reason Daisy has to pay estimated taxes is because she’s making a profit. She’s got that \$4,000 of profit sitting in her business bank account. She can make a payment to herself because she owns the company. She’s paying herself a draw (or maybe with an S Corp a salary), but when you own the business and you have a separate business account, you are allowed to pay yourself from the account.

Next question: But isn’t it a waste of time? Aren’t you writing two checks-one to Daisy and then one to the IRS, when writing one check directly to the IRS would solve the problem? No, it’s not a waste of time because it’s worth the extra five minutes to keep your books straight.

If you keep your business books strictly for business, with no personal expenses running through there at all, the IRS is going to think you’re pretty boring and not worth wasting much time on trying to audit you. This is one of those times where boring is good! Remember, paying your estimated taxes out of your business account is seen to be the same as taking your kids to Chuck E. Cheese’s Pizza. It’s a cheesy expense! (Sorry, that pun flew out of the keyboard, I couldn’t stop it.)

Many small business owners get into tax trouble because they wind up using their business accounts for personal spending. While your estimated tax payment seems like it would be a business expense, it’s not and you have to keep it separate.

# Filing a Tax Return For Your LLC

Photo by Lancashire County Council on Flickr.com

If you’ve started a new business and you filed the Articles of Organization in your state to become an LLC, then here are some things you need to know about filing taxes for your new company.

First, there is no such thing as an LLC tax return.  I know that sounds crazy, but it’s true.  Every year, thousands of people walk into their accountants’ offices and say, “I want to file an LLC tax return!”   This is what accountants joke about at their conventions and at the water cooler.  We even post silly You Tube videos about it.  This post is to help you not be the butt of some dumb accounting joke.

An LLC is a Limited Liability Company.  One of the most common mistakes people make is that they think LLC means “Corporation”, it doesn’t.  If you have an LLC, you probably are not going to file a corporation return (although you might, I’ll discuss that later).

The IRS considers an LLC to be something they call a “disregarded entity.”  That means that it doesn’t have a specific tax document that goes with it.  If your LLC only has one “member” (member is LLC-speak for owner) then the default tax return for your LLC is a Schedule C which is part of your 1040 income tax return.  It’s due on April 15th just like any other individual tax return.

If your LLC has two or more members, then by default you are considered to be a partnership and you must file a partnership return, form 1065.  Form 1065 is due on April 15th also, but it’s a good idea to get it done sooner because the information on the 1065 needs to go onto your personal tax return before you file it.   When your accountant prepares the 1065, she’ll also prepare a K-1 form that will be used to prepare your personal income tax return.

So, if you have an LLC, the default tax return you might file would be a Schedule C as part of your individual income tax return, or a 1065 partnership return (and you’d receive a K1 form so you could put your partnership income on your personal tax return).

Instead of using the default filing options, you can choose to have your LLC treated as an S corporation or a C corporation for income tax purposes.  It’s very rare to choose to have your LLC treated as a C corporation.  Usually, if a person wanted to pay corporation tax rates, she would file articles of incorporation to begin with.  But one advantage to filing as an LLC and then electing to be taxed as a C corporation would be to avoid some of the stringent reporting and meeting requirements that C corporations have.  Usually, it’s not advantageous tax-wise to be treated as a C-Corporation, but there are always some exceptions.  If you do go this route, you will need to file an election to be taxed as a corporation: form 8832.  The tax return for a C-Corporation is called an 1120.  You must file the 1120 or the extension by March 15th or you will be assessed a late filing penalty even if you owe no tax.  A C-Corporation pays taxes on its income and pays wages and/or dividends to the owner.

The more common corporate tax treatment for LLCs is to be taxed as an S Corporation.   A Sub-chapter S corporation passes its profits through to the owner.  If you elect to be a Sub S Corporation, you must pay yourself a wage.  For most businesses, the purpose behind a Sub-chapter S corporation is to avoid paying self-employment taxes.  There are two things you must know:

1. A Sub S Corporation isn’t always the best way to avoid paying self-employment taxes and,

2. You’re not allowed to say that you’re trying to avoid paying self-employment taxes, even though that’s pretty much the reason anybody ever makes the Sub S election.

To make the election to be taxed as a Sub S Corporation, you will need to file form 2553.  A Sub S Corporation tax return is called an 1120S form and it is due by March 15th.  The S corp does not pay income tax; the income from the S corp will be reported on a K1 and will flow through to your personal tax return.

If you make an election to be taxed as a C or an S Corp, you will have to keep that designation for at least five years unless you get special permission from the IRS to change.  You want to make sure you really want to make the election for corporate tax treatment before filing those forms.

Here’s my really important tax advice:  Assume that you’re filing your LLC return either as a Schedule C (sole proprietor) if you’re a solo owner, or a 1065 partnership return if you have more than one owner, at least for the first year.  But then, sit down with your preparer and run the numbers all three ways, (Schedule C, S-Corp, C-Corp) to see what makes the most sense for your business.  Make some projections about your future income and expenses and take into account the deductions that you may have missed last year but won’t miss again.  Smart planning can save you thousands of dollars in taxes over the years to come.  Saving on taxes helps your business grow and puts money in your pocket.