How an S-Corp Election Can Cost You Money
s-Corp election for llcs & corporations
There are a lot of wrong impressions of the S corp election. A big one is that you get an S corp. at a State. The “S corp” is simply an election with the IRS, and you can make the S corp election on an LLC. You DO NOT have to have a corporation to make the S corp. election. The second big wrong idea is that the S corp. automatically saves you 15% on your taxes. Though it is a savings, it’s only on the amount you take as a dividend.
The S corp. election is a common election for regular corporations and LLC’s. If you declare your company as an S corp., you will have to pay yourself a regular W2 wage. This means establishing payroll and withholding for yourself with the IRS and the State you’re a resident in.
The advantage to this is the capability to divide up your profits between payroll and dividends.
What this means is, you will pay yourself a “regular” wage for someone in your role. (This is what the IRS says, and it has to be a wage you would pay someone if you hired that person for your role. Obviously, if it’s a new company, the wage doesn’t have to be that high.) and if you have left over profit, you can pull that down to yourself as personal income as a dividend. Dividends avoid the self employment tax (15%) and/or payroll taxes, such as Social Security and Medicare withholding. This adds up to 15% because as the employer, you match the Medicare and Social Security withholding you take out of your employees’ checks. In your personal case, you will be the employee anyway, so that is why you’re paying it twice. The current Social Security tax rate is 6.2% and the current Medicare tax rate is 1.45%. So as an employee, you get 7.65% of your check withheld, and as the employer, you match that to the IRS Federal Insurance Contributions Act (FICA), making your total 15.3%. That means whatever profit you can take as a dividend, you can avoid the 15.3% tax on that dividend dollar amount.
You see if you are a sole proprietor, you will pay the 15% self employment tax for Medicare and Social Security anyway, so there’s no special treatment on a sole proprietor, except that it’s less paperwork to keep track of your books, and you can run into an H & R Block and usually find someone to do your taxes for about 400 bucks as opposed to a CPA.
If you pay yourself a wage, you will have to pay the Social Security and Medicare. So if you end up with $10,000 net taxable income at the end of the year, and you divvy it up by paying yourself $5,000 for the year, you’ll take a $5,000 dividend, and thus save the 15% of $5,000 dollars.
Or if you’re a C corporation:
The corporate income tax rate is usually higher than the personal tax rate. If you have a regular C corporation, you’ll keep the profits of the company at the corporate level. You don’t have to pull it down to you personally. If you ever decide to take a dividend, you’ll be paying tax twice though.
If you declare your C Corporation an S corp., you’ll have to pull the net taxable income down to the shareholder’s personal tax returns, and pay the profits at whatever taxable income bracket you’re in. This usually will save you a lot of taxes unless you plan on keeping a lot of cash in the company, and ultimately re-investing it back in the company.
If you would like to make the S corp. election with the IRS, we would be glad to help you make this step.
What Exactly is an S-Corporation?
“S-corporation” is a tax status given by the IRS. A business that wishes to be taxed as an S-corp must apply to change their status with the IRS. First, your business must qualify. The IRS has specific qualifications, and if you do not meet them you cannot be granted an S-corp election.
Is an S-Corp a Different Entity Type?
No. It is a common mistake, but an S-corp is not an actual entity type. It is simply a tax status granted by the IRS. If you are an LLC, you can apply to be taxed as an S-corp. Your business will still be an LLC, but you will be taxed differently by the IRS.
Who Can Be an S-Corporation Shareholder?
The IRS has specific qualifications for who can be a shareholder/member of an S-corp. Only the following are allowed to be shareholders/members of an S-corp:
- US Citizens
- Permanent Residents
- Single Member LLCs Owned by a US Citizen or Permanent Resident
- Qualified Subchapter S Trusts
- Certain Voting Trusts
- Grantor Trusts
- Bankruptcy Estates
- Revocable Trusts Created as Part of an Estate
- Certain Exempt Organizations
C-corporations, nonresident aliens, partnerships, multi-member LLCs, LLPs, and foreign trusts cannot be shareholders/members of an S-corp.
What Are the IRS Restrictions for S-Corps?
The IRS has specific requirements for S-corp election. To apply for S-corp status, your company must meet all of the following:
- Be a Domestic Entity
- Have Allowable Shareholders/Members
- Have No More Than 100 Shareholders/Members
- Have Only One Class of Stock
- Not Be an Ineligible Entity
What Are the Advantages of an S-Corp?
- No Double Taxation
- Taxed on Wages of Shareholder Employees, Not on Net Income
- Distributions Taxed Lower Than Employment Taxes
What Are the Disadvantages of an S-Corp?
- Corporate Formalities Required by Law
- Shareholder Employee Salary Must Be Competitive
- Audits Can “Re-Distribute” Salary and Distributions