March 9, 2020
S-Corps and Self Employment Taxes
Reduce Self-Employment Tax with S-Corp
As a self-employed professional or a business owner, you’ve most likely heard about the S-Corporation election from colleagues and tax experts. We’ve mentioned those briefly in a previous post and would like to dive deeper. Many owners say “I’m not there yet”, or “I heard there is so much extra work and paperwork associated with electing an S-Corp structure for my LLC”. But for many of us, taking that extra step, maybe with some affordable help from a professional, can save a lot on self-employment tax.
Over the past ten years or so, we have seen the benefits of California Sole Proprietorship structure decrease dramatically, as it gives no liability protections, and very little room to affect your tax destiny. A single-member LLC is a simple method to get out of the Sole Prop structure and add some liability protection so that your personal assets (cash, investments, property) have some protection from the debts incurred by your business. If you make less than $60K from your business, an LLC is a great structure for you.
When should I go with S-Corp?
If you make more than $60,000 a year, you may want to consider the S-Corp election. It basically means that you are electing to have your business be treated as a corporation, and you are now a salaried employee of your business. You pay yourself a payroll, also called W2 income. This allows you to pay self-employment tax (15.3% in 2019) only on your salary, instead of on all your business income.
You must pay yourself a “Reasonable Salary” as specified by the IRS. Unfortunately, the IRS does not narrow its definition down any more than that, leaving it up to the individual owners and their accountants to make the decision of the salary they pay themselves.
Example
To illustrate: Say two identical businesses both made $100K in 2017: Pam's Real Estate is a single-member LLC, while Beth's Homes & More elected to become an S-Corp.
Beth's Homes & More will pay less than half of the Self-employment taxes that Pam's Real Estate will pay, just by being an S-Corp and paying out a salary. Both companies will pay Federal Income Taxes on the Net Income of the company. If the owners withdraw more cash than the salary, this is recorded as an Owner's Distribution and does not influence Net Income, therefore it does not have an effect on the amount of Federal Income Tax paid.
Summary
Over many years of experience, we have found that the S-Corp is the best structure for Self Employed, mainly Service Professionals making $60K or above. While there are a few industries or scenarios where staying in an LLC or Sole Prop may be more beneficial, most 1099-earning service professionals will find the most benefit with an S-Corp structure.