November 14, 2019
Many business owners are astounded when they hear about the potential tax savings associated with S Corps. Although it sounds too good to be true, establishing a business as an S Corp is a relatively painless process with minimal risk and massive upside. Further, most small businesses in the U.S. indeed qualify for S Corp status. The obvious question is, why doesn’t every business owner turn their business into an S Corp?
The answers to this are manifold, but perhaps the biggest barrier is a lack of knowledge. For example, many owners don’t entirely understand the difference between the different types of business entities (such as sole proprietorships, general partnerships, LLCs, and corporations).
Understandably so, the legal distinctions between these entities can get complicated and nuanced, and structural decisions regarding a business are best handled by a legal professional, a tax advisor, or both. Choosing or changing a business entity can have nontrivial consequences on an operation in both the short- and long-term. For this reason, business owners must make a prudent and informed decision when it comes to declaring an entity or to changing from one entity to another.
Nonetheless, choosing the most appropriate entity for a particular business can result in major savings for owners. Take S Corps for example; many sole proprietorship and LLC owners are paying a substantial amount of taxes per year, some of which could be reduced by taking advantage of the S Corp tax structure.
S Corps and Other Types of Business Entities
A business entity—also called a business structure—is simply a legal construction through which an owner decides to operate their business. There are four general types:
- Sole Proprietorships: unincorporated entities that are highly flexible and are subject to few regulations. Sole proprietorships don’t offer liability protection and are taxed on the owner’s personal tax returns.
- Partnerships: unincorporated entities that are also quite flexible. Similar liability and tax treatment sole proprietorships.
- Limited Liability Companies (LLCs): incorporated entities that are subject to some formalities. LLCs do offer liability protection to owners but are—by default—pass-through tax entities, similar to sole proprietorships or partnerships.
- Corporations: incorporated entities that are structured and subject to various corporate formalities. Corporations come in two forms: S Corps and C Corps. Both offer liability protections for owners, but C Corps are highly structured and generally meant for larger companies. S Corps (Small Business Corps) on the other hand, are a bit more flexible. S Corps and C Corps are also taxed differently.
Notably, the latter two entities are considered incorporated structures, meaning that they provide liability protection for owners. This is sometimes referred to as the corporate veil, and it’s an incredibly valuable layer of insulation for owners. Another key consideration is taxation; nonincorporated businesses and conventional LLCs are taxed on the owner’s personal tax return—allowing flexibility, but also rendering them liable for self-employment taxes. Some LLC owners can avoid these levies by taking advantage of the S Corps tax structure.
The Tax Savings Associated with S Corps
Both LLCs and S Corps are considered pass-through tax entities, meaning that the profits/losses generated by the business can be declared on the owner’s individual tax return. This may or may not be beneficial for owners depending on their tax bracket. Perhaps a more important consideration is self-employment taxes. According to the IRS:
“Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners.”
For LLC owners, all business profits are subject to self-employment taxes. However, for S Corps, only the owner’s salary is subject these mandatory levies. These taxes aren’t nominal; as of 2018, self-employed individuals are subject to a 12.4% social security tax as well as a 2.9% Medicare tax. In other words, most LLCs are subject to a 15.3% mandatory tax on all business profits. However, S Corps avoid some of these taxes by ensuring they’re imposed only on the owner’s salary, not all business profits.
So can an LLC save $15,000 per year by switching their entity to an S Corp? They certainly can, let’s take a look: suppose an LLC generated $180,000 in profits in 2017. The self-employment taxes imposed on this sum would total $27,540 ($27,540 is 15.4% of $180,000; around $22,000 in social security and an additional $5,000 in Medicare). Now let’s assume the owner changed their LLC into an S Corp the following year and again generated $180,000 in profits. This time, the 15.3% self-employment tax would not be imposed on the entire $180,000 sum, but instead only on the owner’s salary. If we assume that the owner set their 2018 salary at $80,000, then their self-employment tax burden would only be $12,240 (15.3% of $80,000), amounting to $15,300 in tax savings. In broader terms, anytime an owner’s salary is about $100,000 than the company’s revenue, a savings of $15,000 is achievable.
This is the principle reason why small business owners turn their LLCs into an S Corps, either by: 1) maintaining their LLC but requesting S Corp taxation status, or 2) by structurally changing their LLC into an S Corp and transferring their assets. Either way will result in S Corp taxation, which can significantly reduce the self-employment tax burden. One last consideration worth mentioning is the practice of “setting” a salary. Many owners have difficulty establishing a seemingly-arbitrary salary for themselves, and it’s difficult to overlook the fact that their salary has a direct effect on their tax burden.
Consulting an experienced professional would be wise in this situation. According to the IRS, an owner’s self-declared salary must be reasonable, but what exactly constitutes as “reasonable”? The agency surely monitors this issue closely, and will take action if any foul-play is suspected.
