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S-Corp Election, Reduce Self-Employment Taxes

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By Watson CPA Group ()

Posted February 25, 2017

 

There is a misconception floating around out there that an S-Corp is a standalone entity. Not true. There are basically three broad types of entity formation- Partnerships, Limited Liability Companies (LLCs) and Corporations (C-Corps). Each can elect to be treated as an S-Corp for taxation purposes under subchapter S of the revenue code, but the underlying entity and subsequent corporate governance is either a Partnership, LLC or C-Corp.

 

So while we might talk about your ‘S-Corp’, or ‘S-Corp Taxes’, we are truly talking about your partnership, LLC or C-Corp being treated as an S-Corp for taxation. Again, this is a common misconception… no biggie if you thought otherwise.

 

Avoid Self-Employment Taxes

A common complaint from those who own their own business is self-employment tax. Can you avoid, reduce, eliminate or lower your self employment taxes or SE taxes? Yes, to a large extent actually but it takes some effort and an S-Corp Election.

 

If you own a business as a garden variety single-member LLC (one owner or shareholder), your business income will be reported on your personal tax return under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. The same is true for a business that has not formed a corporation such as a sole proprietor and partnerships. So, you could easily pay an average of 40% (15.3% in SE taxes + 25% in income taxes) on all your net business income in Federal taxes. Wow!

 

S-Corp Election

If you own an LLC and have elected to be treated as an S Corp (Subchapter S) for taxation, the business now files a corporate tax return on Form 1120S. What’s the big deal? Before we get into that, let’s look at some quick numbers. These are based on using a salary of 40% of net business income for incomes up to $500,000 and then decreased incrementally to 30% for the millionaire at $2,500,000 below (real case actually.. right Bernie?)-

 

Income

Total SE Tax

Salary

Total PR Tax

Delta

Delta%

30,000

4,239

12,000

1,836

2,403

8.0%

50,000

7,065

20,000

3,060

4,005

8.0%

75,000

10,597

30,000

4,590

6,007

8.0%

100,000

14,130

40,000

6,120

8,010

8.0%

150,000

18,711

60,000

9,180

9,531

6.4%

200,000

20,050

80,000

12,240

7,810

3.9%

300,000

22,972

120,000

18,174

4,798

1.6%

500,000

29,991

200,000

20,494

9,497

1.9%

750,000

38,764

262,500

22,307

16,457

2.2%

1,000,000

47,537

350,000

24,844

22,693

2.3%

2,000,000

82,630

600,000

32,094

50,536

2.5%

2,500,000

100,177

750,000

36,444

63,733

2.5%

Don’t get too hung up on the drop in percentages. Focus on the overall hard dollar amount. Notice the sweet spot at $100,000 to $150,000 (yes, it dips at $300k due to Social Security limits). Also consider that if you run self-employed health insurance through the business (and you should), savings jumps up even more. Why? Check out our Taxpayer’s Comprehensive Guide to LLCs and S Corps which expands on this concept-

 

 

Bottom line savings is about 8-10% of your net business income after expenses. So, if you make $100,000 after expenses you’ll save about $8,000 in overall taxes, and they are all self-employment taxes. There is a cost to being an S corporation of course- all that glitters is only partial gold. See below for our S corp “all in” package.

 

Money Trail for S-Corp Elections

So, when your partnership, LLC or corporation is an S-Corp you are both an employee and a shareholder (think investor). As an employee, your income is subjected to all the usual taxes that you would see on a paystub- federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment and disability. However, as a shareholder or investor, you are simply getting a return on your investment much like a dividend.

 

A K-1 is a statement that each shareholder receives, and it is similar to a W-2 since it reports the income that each shareholder is responsible for from a taxation perspective. There are two types of K-1s for the purposes of our discussions- one is generated from a Form 1065 and the other is generated from a Form 1120S. A Form 1065 is also called a partnership tax return, and typically your K-1 will be subjected to self-employment taxes.

 

However, a K-1 generated from a Form 1120S (LLC or C-Corp, either with the S-Corp election) is reported on the shareholder’s personal tax return on Schedule E. Schedule E is the form used for rental properties, royalties and other investment income including business income from an S-Corp.

 

And when we say self-employment taxes, we are really talking about Social Security and Medicare taxes. From a sole proprietor perspective, they are self-employment taxes. From an employee perspective, they are Social Security (FICA) and Medicare taxes. Same thing.

 

Let’s look at another visual in terms of how the money travels (picture time!)-

 

 

So an S-Corp doesn’t pay taxes per se since it is a pass-thru entity, and passes its tax obligation to the investors. Tthere are some states that charge a franchise tax such as California and Texas, and other states have an S corporation tax that is egregious such as Tennessee and New York City. Please read the full story on S-Corporation taxes and self employment taxes in our Taxpayer’s Comprehensive Guide to LLCs and S Corps-

 

 

Late S Corp Election, Oops

Form 2553 (the S-Corp election form) must be filed with the IRS. It is typically due within 75 days of forming your business entity, however, there is relief for the late filing of Form 2553 and we can guide you through that. IRS Revenue Procedures 2003-43 and 2004-48 used to be the governing rules but the IRS has simplified it (imagine that!). We have an entire webpage dedicated to the late S Corp election. We can go back to January 2016! Check it out here-

 

 

S Corp Package

The Watson CPA Group specializes in S corporations which have a small number of shareholders, and often just a one-person show. Because it is a core competency for us, we have created an S corp package that includes the following (No, the S doesn’t stand for stormtrooper)-

 

  • S Corporation Tax Prep (Form 1120S)
  • Individual Tax Prep (Form 1040)
  • S Corp Payroll Events (required by IRS), Filings and Deposits
  • Estimated Tax Payments (done thru payroll)
  • Q3 Tax Modeling and Projection (Questionnaire)
  • Unlimited Consultation and Periodic Business Reviews (PBR)
  • Small Business Tax Deductions Optimization
  • Annual Processing (W2s and other filings)
  • IRS Audit Defense

Our annual fee for the S Corp package is $2,640 (or about $220 per month). Do you want to parse it out? Sure. If you did your own payroll processing, our fee reduces to $2,160. Perhaps saving $480 to add chores to your Sunday is a consideration (yup, that’s a bit sarcastic… our apologies). Frankly we make very little profits on payroll processing- we offer it as a convenience to our clients. One throat to choke with a single call can be reassuring.

 

If you do your own individual tax return, our fee reduces to $2,240. However, the benefit of the Watson CPA Group preparing both tax returns is that we slide things around depending on income limitations, phaseouts, alternative minimum tax (AMT), etc.

 

The button below links to our Periodic Business Review (PBR) Agenda. We use this throughout the year as a checklist for our business clients. We can also use it for any type of business consultation.

 

 

 

Since we are so far into the year, our fee for the rest of 2016 is a bit different-

 

  • $375 for late S Corp election ($300 for timely elections)
  • $300 for payroll setup
  • $350 for Q4 payroll event (to encompass entire year), with consultation
  • $700 to $950 (typical) for S corporation tax return for 2016
  • Start with S Corp package on Jan 1 2017 (outlined above)

How does all this work? Let’s chat! Your unique situation will probably fit the S corporation world, but a dialogue is much better to determine the viability. Contact us to schedule a consultation. If all goes well, we will prepare a proposal which outlines the scope of services. View a sample proposal here.

 

S Corp Election Checklist

Before we get into the fees and how it works, and all that jazz let’s go through a quick checklist to ensure that we are not going down the wrong road-

 

  1. Does your business earn over $30,000 net income after expenses? Say Yes.
  2. Are you located in New York City or Tennessee where S corporation tax rates are egregious and suck up all the federal tax savings? Say No.
  3. Do you have other W-2 income that exceeds or comes close to exceeding the Social Security limits of $118,500 (2016) or $126,200 (2017)? Say No. If you say Yes, we need business income to exceed $80,000 in #1 above.
  4. Is this a going concern? In other words, is the business going to continue to earn the same income or more each year? Say Yes.
  5. Do you have an LLC or some other entity in place that can be elected to taxed as an S Corp? Say Yes. If you say No, we have options just not elegant ones.

Are you still here? Excellent news… let’s chat!

 

Self Employed 401k Plan

Now that you can save thousands of dollars in self employment taxes with an S Corp election, you should invest that wisely. The Watson CPA Group is a small business too, and we understand that any extra dollars usually get invested back into the growing company. Having said that, there are several small business retirement plans which include solo 401k plans, profit sharing plans, cash balance and defined benefits pensions.

 

For example, with a solo 401k plan piggybacked with a defined benefits pension, you could sock away over $192,000 at age 50. All tax deferred if you like, which could yield a savings of over $86,000 (assuming a 45% marginal tax rate with federal and state). Wow!

 

Note how we purposely did not mention SEP IRAs. These are old school and are usually designed to be crisis management tools (after the fact) rather than good planning tools. Read more about the various self employed retirement options, including retirement tax bombs and the difference between tax deferral and tax savings below-

 

 

Please contact us today to get started on electing S-Corp status! All the cool kids are doing it- well, most, and we’ll have to ask several questions to make sure the fit is right.

 

The Watson CPA Group (team profile)