This article isn’t meant to substitute for the advice of a tax practitioner. If you are considering changing your small business’s entity type, please consult your personal tax practitioner or call our office at (866) 316-1860 or arrange for a video chat with me at https://heritageincometax.com/book-online.
You’ve been running a small business for a few years and are shocked at the amount of taxes that you’re paying. Let’s face it: sole proprietors (or single-member LLCs) and partnerships pay 15.3% tax towards self-employment taxes alone, and then the profits are also taxed as income at the federal, state, and sometimes the city level. I’ve had a few folks in tears in my office when their failure to make estimated quarterly payments caught up with them. Not pretty.
So, you begin your research into the world of tax strategies. You conduct internet searches, hit the library, watch some business guru videos on YouTube, chat up a friend, or your barber, and someone inevitably mentions the amazing tax savings you might enjoy as an S-Corporation. So you look up the filing requirements and they are deceptively simple. Complete a form 2553 and send it to the IRS, and you now can write off your profits free and clear of self-employment taxes. Right?
Not so fast!
Let’s review the basics of an S-Corp. First, S-Corps become their “own” company. You as the former sole proprietor now are employed by your own S-Corp. This has a few consequences, both positive and negative. It’s up to you to decide if the financial advantages outweigh the reporting and payroll compliance requirements and then proceed cautiously, with professional assistance.
Wages vs Distribution [W-2 income vs K-1 Distribution]
S-Corp profits are taxed as ordinary income, and not subject to employment (FICA) taxes. This used to be a shady strategy: Pay yourself a giant distribution from your S-Corp, and ignore the payroll tax requirements. However, the IRS caught on to this a while back and issued rules about how S-Corps must compensate their employees.
S-Corps are required to pay employees (even the sole shareholder) a reasonable salary. This means that the IRS may audit your business and evaluate if you’ve paid yourself enough salary – I will explain the reasoning for this later on. A reasonable salary can be estimated between the 25th and 75th percentile of what similar positions in your region are paid. Anything too low and the IRS may reclassify your distributions from the K-1 portion of your income as “salary” and charge you the delinquent FICA taxes, plus penalties and interest.
Payroll Tax Requirements
Your salary (and any other employee-shareholder’s) will be W-2 reported income, so whatever you’re paid will be subject to federal, state, and FICA withholdings (social security and Medicare taxes). You may also live and work in a city/municipality that charges income taxes, so those taxes must be withheld as well.
Your S-Corp must maintain compliant payroll – paying you regularly, filing forms 941 or 944, and making quarterly payroll deposits to the federal government. Failure to do so will trigger a 10% penalty if all you choose to do is report your wages in quarter 4.
Maintaining payroll costs time and money or both. You can use a payroll company such as Paychex or Gusto to automatically manage your withholdings but again, this is a cost you must consider. Typical payroll expenses for a very small business run between $29 and $300 per month.
Filing Corporation Informational Tax Returns
Tax returns for S-Corporations are more expensive, complicated, and time-consuming to prepare. (My tax practice charges no less than $1000 for an 1120S. This price does not include the taxpayer’s personal 1040.) S-Corporations do not actually pay any income taxes – the shareholders report their share of the profits once the S-Corp has filed an informational return (a 1120-S). The 1120-S includes schedule K-1s for every shareholder and W-2s for every employee. Employees who are also shareholders will receive both a W-2 and a K-1. The K-1 is the way you will report your fair share of income and expenses to the IRS. It is not necessary to have the same tax preparer prepare both the 1120-S and your personal taxes, but you may be able to get a better price by hiring one tax practitioner to prepare both.
It is not a good idea to try to prepare an 1120-S yourself, unless you are trained in business tax preparation. These returns are much more likely to be audited by the IRS, and an untrained person will quickly become confused about allowable expenses vs. separately stated items.
An S-Corporation vs Sole Proprietor/Schedule C Cost Comparison Calculator
If you are interested in a business planning video chat, I have a beautiful excel spreadsheet created by a fellow tax professional friend of mine. She is graciously allowing me to use it with my clients to help them decide if the costs of S-Corporation payroll and tax preparation are worth the tax advantages of the election.
Please call me at (866) 316 1860 or self-schedule using our Calendly App for a video chat. I will share my spreadsheet results with you and assist you in making an informed decision about this election.