Category: S Corporations

Posted on by Jan Roberg

S Corporation – Computing the Tax Savings

 

Run the numbers.

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

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

Posted on by Jan Roberg

Should Your LLC Be an S Corporation?

When should you be an S Corp?

If your small business has reached the point where your self employment taxes are really hurting you, choosing an S Corporation status might be the answer to your problem.

 

If you own a single member LLC, the IRS considers that to be a “disregarded entity.”  That basically means there’s no such thing as an LLC tax return.  So, if you don’t make an “election” to taxed some other way, you’re taxed as a sole proprietor on your 1040 personal tax return.  That means, you not only pay income tax on your LLC income, you also pay self employment tax on top of it.  Ouch!

 

But as a disregarded entity, you may make an election to be taxed as an S corporation (or even a C corporation if you want to) instead of being a sole proprietor.  So how do you know you might be ready to be an S Corp?   Here’s my top three criteria:

 

1.  Steady net income.  If you have a loss on your business, that business loss can offset your other income on your tax return.  One of the big benefits of an S corp is to reduce your self employment tax.  If your business has a loss, you’re not paying self employment tax anyway so the S corp status wouldn’t provide much benefit there.  A good rule of thumb, but certainly not a deal breaker, is to have a net income of about $50,000 to make the tax savings be greater than the additional cost of separate tax returns and payroll expenses.  I work with business that have losses and still are S Corps.  The $50K income isn’t a requirement, it’s just sort of a break even point on costs.

 

2.  Separate Employer Identification Number (EIN)  and bank account.  If your business is set up as an LLC, you should have a separate EIN and a bank account for your business already.  I’m always surprised by people who skip this step, but it’s important.  You can get an EIN number for free, online.  It takes about 5 minutes.

 Learn more here.

And you really need a separate bank account.  You don’t want to co-mingle your business funds with your personal money.

 

3.  Discipline to make monthly payroll deposits and quarterly reporting.  One of the requirements of an S Corporation is that the owner has to pay him or herself a reasonable wage.  That means, even if nobody else works for you, you still need to write yourself a paycheck and pay yourself like an employee.  If you’re already making your quarterly estimated tax payments–you’re probably able to handle doing a payroll.  If you’re scrambling every year, you can’t keep on schedule etc, then I say don’t do the S corp.  Not being up to date on your estimated payments can be a problem, but the IRS can get really nasty if you’re behind on payroll tax deposits.

 

If you have no discipline, and your business easily has enough revenue to handle the payments–and still want to do the S Corp, then pay the extra money to hire a payroll company to do it for you.

 

Setting a reasonable wage is usually the most difficult thing to determine.  You want to go by what a person in your line of work would get normally get paid, that’s not always easy to figure.  You should probably have your wage be at least 1/3 of your net income unless you can document that people in your line of work usually make less.

 

Now, these are just my guidelines.  There’s really no “set in stone” criteria for S Corp status.  And really, before you make any change to the status of your business, what you really should do is run the numbers.  Sit down with your tax professional and – using the most recent tax return – run the business numbers as if you were an S Corp, a C Corp, and as a sole proprietor.  Don’t forget to include the costs of your payroll taxes when running the numbers.

 

Everybody’s situation is a little different.  Compare your numbers side by see to see if changing to an S Corporation makes sense for your small business.  That’s really the best way to tell.

 

 

 

Posted on by Jan Roberg

Tax Planning Strategy for High Income Earners with S-Corporations

Are you a high income individual with an S-Corporation? Photo by Jacob Bøtter at Flickr.com

 

Whenever I’m talking about tax strategies for high income earners with my clients they always ask, “What do you mean by high income?”  If I’m talking to a person face to face and I bring up tax strategies for high income earners, I mean the person I‘m talking to.  I wouldn’t bring it up otherwise.  Since you happen to be reading this on the internet, for this post I generally mean people with incomes over $200,000.

 

Here’s what’s up:  The new Medicare tax on investment income (or Obamacare tax, Net Investment Income tax, Healthcare tax, or whatever you want to call it) also taxes your  S Corporation profits.  Let that sink in for a minute.  S Corporation profits will be counted in the same category as interest and dividends and capital gains for the 3.8% Medicare investment tax.

 

Let me give you an example of how this could affect you:  Let’s say you’re single and you have wages of $150,000 and S-Corp profits of $200,000 for a total of $350,000 in Adjusted Gross Income.

 

To figure the medicare investment tax you’d take $350,000 – 200,000 (the base) = $150,000.  You have $200,000 in investment income, you’re only going to pay the 3.8% on whatever is over the base so your Medicare investment tax is 3.8% time $150,000 which equals $5,700.

 

At $150,000 on wages, you’ve already maxed out the Social Security withholding that you were subject to so additional Social Security tax doesn’t affect this example.

 

Now let’s compare your investment Medicare tax with your wage Medicare tax.   Withholding on your wages is 1.45%, plus the employer contribution on your wages is an additional 1.45%–so as the owner/employee of your S-Corp you’re paying 2.9% Medicare taxes on your wages.  Once you cross the $200,000 wage point, there’s an additional 0.9% Medicare wage tax bringing the Medicare wage tax to 3.8%.  That’s the same rate as you would pay with the Medicare Investment tax.

 

It used to be that one of the benefits of being an S-Corporation was that you didn’t pay the extra 2.9% (now 3.8%) Medicare tax.   You’re losing the savings benefit you used to have.

 

Now this doesn’t affect everybody.  If your S-Corp income is lower, this might not matter to you.  That’s why you have to do some comparisons.

 

So, a really important question for you is going to be–is your S Corporation still the right business structure for you?  For some people, the answer will be yes.  For others, it might be time to convert to a regular C Corporation, a Sole Proprietorship, or Partnership.

 

The Obamacare tax will be reported on Form 8690 and added to your 1040 personal income tax return.

 

How can you tell?  This year, more than any other year, you want to get your taxes done on time.  Run the numbers all the ways that you’re thinking about.  Be sure to figure things based on the changes you’d make if you had a different business structure.  Then you can make an informed decision based on the numbers.

 

Remember, your corporation taxes are due by March 15th.  If you want to revoke your S-Corp election for 2014, you have to do that by March 15th of 2014 otherwise it will be too late.  Of course, you can revoke your S-Corp election and still file an extension for your 2013 taxes.  But the smart thing is to run your numbers before you revoke the election–because you still might be better off keeping your S-Corp.   For many companies, changing your corporate status will give you no benefit–for many others it will.  That’s why it’s so important to make the decision with your eyes wide open and with all the facts in your hand.