When you own a business, you may hear about electing S-Corporation status. Learn what that means and what factors you may want to consider before making this choice.
Tax law change and QBI
Prior to 2018, many small businesses formed an S-Corp once their business made a decent annual profit, over $50,000 or sometimes over $100,000. This is because an S-Corp reduces the social security and medicare tax paid by the business owner. Social security and medicare tax can be as much as 15.3% of business profit for a sole proprietor or LLC business and the opportunity to save 15.3% on a portion of earnings is appealing.
However, in 2018 the tax law changed. Small businesses received a new deduction of up to 20%, significantly reducing income tax for most small businesses. This Qualified Business Income (QBI) deduction applies to pass through income from business. It provides more of a benefit to self-employed businesses, because the deduction applies to the entire income earned from the business. It provides a smaller benefit to S-Corps, since S-Corp owners must be paid a salary and QBI does not apply to owners salary.
Pass-through income: when net income of a business "passes through" to the owner this means it is taxed to the owners on their personal income tax return. The business does not owe any income tax on these earnings.
The result is that while an S-Corp can substantially reduce social security and medicare tax, an S-Corp owner may pay more in income tax. An S-Corp also typically has higher expenses for payroll, accounting and tax preparation fees. The additional income tax and other costs may erode the tax savings entirely.
Making the decision
The best form of business is the one that suits your needs and works for you. The best choice is not the preference of your accountant or attorney, the one they most recommend to everyone else. Professionals are there to help you understand the options, not decide what your business should be or how to run it.
Unfortunately, some tax professionals may be motivated to encourage electing S-Corp status because they know the fees they charge you can increase by double or maybe triple. This is because an S-Corp requires an additional tax filing and the tax return is more complicated. The tax professional is correct to charge more, however, knowing this bias may exist can help you ensure you don't make a decision based on what is best for your accountant. In order to know if an S-Corp is right for you:
For example, say you confirm that an S-Corp will save you $9,000 per year in payroll taxes. That sounds great. But if you will pay an additional $5,000 in income tax, and an additional $2,500 year in payroll and fees. Now your savings are down to $1,500.
With an S-Corp you have to follow additional rules for reimbursing the owner for expenses, need to do an owner reimbursement for home office deduction, health insurance premiums have to run through payroll and owners need to be more careful about how they keep their books and records. Further, if you are paid under a contract as an individual, such as from a university or hospital, the income cannot be assigned to the S-Corp. Only revenue earned by the S-Corp itself can be reported on the S-Corp return.
If after considering all these factors, you determine an S-Corp will benefit you and your business, then you can make the S-Corp election. Either an LLC or a C-Corp can elect S-Corp status. Read below to learn more about each form of business option.
FORM OF BUSINESS OPTIONS
There are five basic forms of for profit business entities.
Sole proprietor means no separate business entity has been formed, the owner and the business are one in the same. The owner may have a doing-business-as (DBA) name, also known as a fictitious name, established with the state or county, or may operate under the owners legal name. Although there is no separate business entity, it's still important to open a business bank account and have accounting records.
Taxes: All income from a sole proprietor business passes through to the owner in the year it was earned.
Other factors to consider: A sole proprietor is the simplest form of business. Little to nothing has to be done to set it up. It can be a great for a business you are operating by yourself. A sole proprietor may not be best if you are hiring employees, as there's no liability protection for wrongful action of employees.
Single-Member Limited Liability Company is a business entity established at the state level, and is separate from the owner. The U.S. federal government does not recognize the LLC and considers it a "disregarded entity." Which means sometimes the IRS treats the business as a sole proprietor. Because it is a separate entity, bank accounts need to be opened in the name of the LLC, not the owners personal name, and contracts and debts also need to be in the name of the LLC.
A Professional Limited Liability Company (PLLC) is a special type of LLC reserved for certain licensed professionals applicable in certain states. Check your state law to understand the rules for forming an LLC or PLLC. For example, in California most licensed professionals are unable to form an LLC. In other states a PLLC can be an option or may be required, the only option, for licensed professionals.
Taxes: Income tax and self-employment tax for a single member LLC are identical to the sole proprietor listed above, and business income is also reported on Schedule C as part of the individual 1040 tax return.
Other factors to consider: A single member LLC is also a simple form of business, and similar to a sole proprietor except there is a legal business entity to provide some protection if the business defaults on debts. Many mistakenly believe that an LLC protects the owner from all lawsuits, which is not correct, but there is some protection for debts and wrongful action by employees. Obtain legal advice and speak with an insurance carrier to learn how you can protect yourself from lawsuits.
Partnership/Multi-Member LLC has more than one owner, with or without the LLC structure. Business bank accounts and credit cards are in the name of the partnership. A partnership agreement is required to show how the partnership operates and how profits and losses will be divided among the partners.
Taxes: Partners pay Income tax and self-employment tax similar to a sole proprietor, however, profits and losses are divided according to the partnership agreement and taxes can be impacted by the agreement.
Other factors to consider: Partnerships can be complicated, especially when operations don't go as expected. Choose partners wisely. Expect higher legal costs to have the partnership agreement periodically reviewed and modified, including whenever tax laws change.
Entity taxed as an S-Corporation means an LLC or a C-Corporation chose to elect to be taxed as a S-Corporation. This can happen if there are no more than 100 shareholders and certain other rules are met. If this election is made, owners that work in the business will be considered both owners and employees of the business and are expected to be paid a reasonable salary.
Taxes: Because an S-Corp owner is an owner and an employee, they are taxed on the salary and the profit separately.
Other factors to consider: The S-Corp return is more complex and so expect to pay double or triple the cost of tax preparation for an S-Corp return plus an individual return, compared to the individual return required for a self-employed owner. The owner will want to establish an accountable plan to be able to reimburse themselves for expenses without having to pay tax on the reimbursement. The owner cannot take the home office deduction on their personal taxes and instead must create an employee reimbursement for any home office expenses. Owners must be careful to only include revenue paid to the S-Corp in the accounting and tax records. Income earned by the owner as an individual cannot be assigned to the S-Corp.
C-Corporation is not a pass through entity. The C-Corp itself pays income tax each year on the profits of the business. Owners that work in the business are also employees and receive a salary via payroll and receive a W2 for those earnings. Profits can be held in the business for a period of time because they do not pass through to the owners automatically. When the Corporation declares a dividend, the profits are paid to the owners and the owner will pay tax on dividends in the year received. This is known as double taxation, because the Corporation paid tax on profits, and owners pay tax again when profits are distributed as dividends.
Other factors to consider: A C-Corp can offer more in the way of employee benefits to owners. Because S-Corps get special tax treatment, owner benefits can be limited. C-Corp owner-employees are treated more like regular employees when it comes to employee benefits. A C-Corp is one of the most complex business formations so explore carefully with an attorney and tax professional before forming a C-Corp. A C-Corp can elect to be taxed as an S-Corp.
A business may also be formed as a non-profit organization in which case you would not be the business owner. The non-profit is operated by a Board of Directors and management team. This option is not covered in this blog post. If you do want to form a non-profit, seek a tax and legal professional who are experienced in that area.
What if I'm already an S-Corp?
An S-Corp is not generally a bad form of business so if you are already an S-Corp there may be no compelling reason to switch back to a different form of business. The current tax landscape may neither give a compelling reason to choose S-Corp, nor a compelling reason to undo it. If you are curious how much an S-Corp is saving you now, you can always ask your tax professional to calculate what it would cost to be taxed another way, and do a comparison, factoring in payroll tax savings, impact of the QBI deduction on income tax, and additional tax prep and payroll fees.
Here are some additional resources that may be helpful as you make your form of business decision.
Owners pay: To learn how business owners pay themselves from the various forms of business, watch this video: https://youtu.be/hEE6f4Y2yQc
Corp owner salary: S-Corp and C-Corp owners must pay themselves a reasonable salary for work they perform for the business, if there is income available to pay the owner. This video explains how to set a reasonable salary and includes a free handout to use: https://youtu.be/7jotL9-APRo
LLC limited liability: There are myths about the legal protection an LLC can provide. It does not protect us from our own wrong doing. We do need various types of insurance for our business so that we can be protected if we are sued. This legal article explains the actual protection an LLC will and will not provide: https://www.nolo.com/legal-encyclopedia/limited-liability-protection-llcs-a-50-state-guide.html
Employee reimbursements: If you have employees or you are an owner-employee of your S-Corp or C-Corp, it is important to establish an accountable plan for employee reimbursement. This ensures that your own and our employee reimbursements will not be taxed. Self-employed owners do not need this to be able to reimburse themselves tax-free: https://www.journalofaccountancy.com/issues/2020/feb/employee-expenses-accountable-plan.html
Starting your business: If you are just starting your business, these 10 essential steps will help you get started: https://www.simpleprofit.com/start
It can be overwhelming to choose your form of business. Making an investment upfront to learn your options and make a careful choice can save you the headache of having to switch your form of business later.Avoid choosing because someone else said it was best, unless you fully understand and agree it's the best choice. Makes some appointments to consult with professionals and discuss until you are confident you are making the best choice for you.
Questions: email [email protected]
Jennie Schottmiller, LMFT, CPA is a licensed marriage and family therapist who practiced as a CPA prior to becoming a therapist. She has an active solo therapy practice and offers courses to help small business owners with accounting, tax and financial analysis matters.
Disclaimer: This blog is for education only. Please consult with a qualified professional when you have any questions about your personal accounting, tax or legal situation. Information contained in this post is for informational purposes only and not intended to replace professional advice.