Hopefully, you have had a chance to read the blog I wrote about understanding self-employment tax. It’s important to understanding this article and it initially introduces the concept of the S-election.
In the previous article, I mention that self-employment tax is the Government’s way of making sure people who are self-employed and not on payroll pay into the Medicare and Social Security systems. It can get very burdensome when your business is doing well. An answer to this may be the s-election, which allows a LLC to benefit from the structure of an S-corporation without the hassle of actually being a S-corporation. S-corporations are more expensive to form, maintain, and there are additional compliance issues that need to be addressed annually. An S-election is a form and a few minutes for a company that is already in place, so significantly easier to do. However, very few people understand the election and most have taken it because someone told them that it was the thing to do without understanding what, if anything, it is doing for them. Here is what this election does:
1 – An S-corporation (or S-election) is a pass-through entity, just like an LLC, which means that the owner(s) are personally responsible for paying the income taxes on the profit of the business. The only taxes the company pays are payroll, sales and property taxes. At the end of the year, each owner will get a K1 through the filing of a corporate return (1120S) detailing what they are proportionally responsible for paying taxes on that flows through to their individual return. If you own 50% of the company, you will pay income taxes on 50% of the profit.
2 – Self-employment taxes are eliminated! This means that the portion you are responsible for at the end of the year will only be subject to income taxes, not self-employment taxes. Prior to this election, the income is subject to BOTH and self-employment tax is calculated before anything else is considered, so it’s difficult to mitigate its effect. This can equate to significant tax savings just on this benefit alone.
3 – You now get to be on payroll! This is important for a multitude of reasons. First, once the S-election is made, owners are required to be on payroll. The Government still wants everyone to pay into the Medicare and Social Security system, so this is how they accomplish this. Second, the owners are getting paystubs. Anyone who has owned a business knows it’s harder to get capital, both for business and personal uses, without those paystubs. The only thing that can be relied on is the tax returns, which is frustrating because it’s my job to make it look like you made as little as legally possible to mitigate tax impacts. Third, the owners just became an expense of the company, which is important to all those single owners out there as, without the S-election, anything you take from your company as pay is a draw, not an expense, which means your profit doesn’t decrease. With the S-election in place you are now part of what drives the profit number down to mitigate taxes and you’re still getting paid.
Remember the table from the previous article showing the impact of self-employment tax?
Here are how those numbers change with the S-election:
This is a MAJOR difference and I am sure many of you, at this point, are thinking, “This sounds great! Why isn’t everyone doing this?!?!” It’s because it’s not a smoking gun for everyone. First of all, the illustrations above are simplified to make a point, but there are other factors that do come into play. Furthermore, there are additional costs that come along with being an S-election. You have to invest in a payroll service, the company now has to pay employer taxes on the payroll, a corporate return now needs to be done at an additional cost, and a host of other expenses. Many times, the additional costs and the savings the S-election will provide in taxes is not enough to justify the change. In my personal experience, the S-election in the state of Virginia doesn’t break even until about $25,000 – $30,000 in net profit. In states like California and New York, that threshold is higher. It’s important to work with your CPA to do an analysis and make an informed decision as to whether the S-election will help because it will shoot you in the foot if it isn’t taken correctly.
This can be a powerful tool if used wisely! Even if you don’t think you meet the threshold or your have other concerns, like the payroll issue, talk to your CPA! They may see or know something you don’t at the moment.