S Corp Election Self Employment Tax Savings

Posted Saturday, December 30, 2023

There’s a misconception floating around out there that an S Corp is a standalone entity. Not true. The S Corp election is applied to an underlying entity with the primary purpose of reducing self-employment taxes. There are three basic business entities, with variations within. The three basic are:

• Limited Liability Company (LLC), single-member or multi-member, including the professional variant (PLLC)
• Limited Liability Partnership (LLP) or General Partnership (GP)
• C Corporation including Professional Corporation (some states require attorneys, accountants and doctors, for example, to be a Professional Corporation)

Two notables missing from the list. First, sole proprietors are not an entity, nor is the variant “Doing Business As” (DBA). If you wake up and want to sell used copiers, you can, right now, without any formalized structure. It’s not smart, but certainly permissible (in some cases it is smart, such as California).

At times, sole proprietors are interchanged with single-member limited liability companies (SMLLC). The IRS and most states consider a SMLLC to be a disregarded entity for taxation. Both a sole proprietorship’s and a SMLLC’s business activities will end up on Schedule C of your Form 1040, however, they are truly different in several underlying ways.

Also note how an S corporation is not listed. It’s not an entity but a taxation election. The underlying entity has to be one of the above, and usually it’s an LLC (either single-member or multi-member) for the ease of formation yet corporations and professional corporations are common as well.

So while we might talk about your “S Corp,” or “S Corp Taxes,” or “self-employment tax reduction machine,” we are truly talking about your underlying entity being treated as an S Corp for taxation. Again, this is a common misconception — No big deal if you thought otherwise — many people do!

A common complaint from those who own their own business centers on self-employment tax: “Can you avoid, reduce, eliminate or lower your self-employment taxes or SE taxes?”

Yes, to a large extent actually, but it takes some effort and an S Corp Election.

As mentioned above, if you own a business as a garden variety single-member LLC (one owner), your business income will be reported on your individual tax return (Form 1040) under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. The same is true for a business that hasn’t formed a corporation such as a sole proprietor and partnerships. So, you could easily pay an average of 40% (15.3% in SE taxes + 25% in income taxes, blended) on all your net business income in federal and state taxes. Wow!

Income taxes are largely a sunk cost. You can reduce it by having less revenue, spending more money on deductible things and / or earning some of the various business tax credits. Therefore, these two tax tiers (self-employment taxes and income taxes) are attacked with different solutions.

If you own an LLC and have elected to be treated as an S corporation (Subchapter S) for taxation, the business now files a corporate tax return on Form 1120S. What’s the big deal? Before we get into that, let’s look at some quick numbers. These are based on using a salary of 40% of net business income for incomes up to $500,000 and then decreased incrementally to 30% for the millionaire at $2,500,000 below (real case actually).

The 40% is purely for illustrative purposes — we needed to pick some sort of salary to demonstrate the efficacy of the S corporation election and reduction in self-employment taxes. Your situation is probably different, and WCG spends a lot of time with small business owners determining reasonable shareholder salary and officer compensation.

Don’t get too hung up on the drop in percentages. Instead, focus on the overall hard dollar amount. Notice the sweet spot at $100,000 to $150,000 (yes, it dips at $300k due to Social Security limits). Also consider that if you run self-employed health insurance through the business (and you should), savings jumps up even more. Why? Check out our book titled Taxpayer’s Comprehensive Guide to LLCs and S Corps, which massively expands on this concept.

Bottom line savings is about 8-10% of your net business income after expenses for those earning $100,000. So, if you make $100,000 after expenses you’ll save about $8,000 in overall taxes, and they’re all self-employment taxes.

Self-employment taxes = Social Security / Medicare taxes = payroll taxes.

All the same thing (in general). This is 8-10% number is just a jumping off point; as the table above shows, the percentage of savings goes down as income increases, but the overall savings continue to rise.

There is a cost to being an S corporation, of course — all that glitters is only partially gold. See below for our S Corp “all in” packages aptly named Vail, Telluride and Aspen. Yup, we’re from Colorado!

Still not sure or not convinced? No problem… please check out Line 4 from Schedule 2 on your Form 1040 tax return. This number reflects the self-employment taxes paid on your business income. We want to reduce this by 60 to 65%, and we assume you do too!

So, when your partnership, LLC, or corporation is being taxed as an S Corp, you are considered both an employee and a shareholder (think investor). As an employee, your income is subjected to all the usual taxes that you’d see on a pay stub: federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment taxes and disability insurance (state specific). However, as a shareholder or investor, you’re simply getting a return on your investment much like a dividend (in S Corp world this is called a distribution).

A K-1 is a statement that each shareholder receives, and it is similar to a W-2 since it reports the income that each shareholder is responsible for from a taxation perspective. There are two types of K-1s for the purposes of our discussions –one is generated from a Form 1065 and the other is generated from a Form 1120S. A Form 1065 is also called a partnership tax return, and typically your K-1 income will be subjected to self-employment taxes.

However, a K-1 generated from a Form 1120S (an underlying entity with the S Corp election) is reported on the shareholder’s personal tax return on Schedule E, Page 2 just like most K-1s, but it’s not subjected to self-employment taxes. Schedule E is the form used for rental properties, royalties, and other investment income, including business income from an S corporation.

When we say self-employment taxes, we’re really talking about Social Security and Medicare taxes. From a sole proprietor perspective, they are self-employment taxes. From an employee perspective, they are Social Security and Medicare taxes (FICA). Same thing.

Let’s look at another visual in terms of how the money travels (picture time!)

An S Corp doesn’t pay taxes, per se, since it’s a pass-thru entity, and passes its tax obligation to the investors. There are some states that charge a franchise tax such as California and Texas, and other states have an S corporation tax that is egregious such as Tennessee, New Hampshire and New York City.

Please read the full story on S corporation taxes and self-employment taxes in our Taxpayer’s Comprehensive Guide to LLCs and S Corps.

Here are the quick benefits of an S Corp election:

• The primary benefit is the reduction of Social Security and Medicare taxes (self-employment taxes).
• You might need to process payroll (pay wages) to avoid being wage-limited on your Section 199A qualified business income (QBI) deduction. An LLC or a partnership cannot pay wages to its owner(s).
• The state and local tax (SALT) workaround only works with pass-through entities (PTEs). Your LLC cannot take advantage of the SALT work-around / PTET deduction without an S Corp election.
• Lower audit risk. Business activities reported on a Schedule C of your Form 1040 tax return tend to attract audits or IRS challenges for auto expense, meals, and travel. Your audit rate risk with an S corporation tax return is 0.4%.
• Certain taxing jurisdictions, such as California, have an egregious tax system that penalizes LLCs with additional taxes. An S Corp election might avoid this or significantly reduce this (in California, a garden-variety LLC is a dirty word).

Do you want a more obscure S Corp benefit? Of course you do!

A Qualified Subchapter S Subsidiary, also known as a QSub or QSSS, is simply an S corporation that’s owned by another S corporation. A QSub is treated as a subsidiary of the parent S corporation. Why should you care? At times, you want to merge two businesses, but the assets are immovable (think of a Medicare certification or a specialized defense contract). You might need to select one before the combination because of certain rules with the merger.

You might also want to combine gross receipts for the passive investment income test, or combine basis between stock and loan basis, or combine to release accumulated earnings and profit (AE&P).

Are you regretting asking? It’s OK — we’ll move along.

So we showed you all the benefits, fees and such… but we need to put the horse back in front of the carriage. Let’s go through a quick checklist to ensure that we are not going down the wrong road. As Doc Brown in Back to the Future says, “Roads? Where we’re going, we don’t need roads.” Well, in S Corp Land, we do:

1. Does your business earn over $48,000 net income (profit) after expenses? Say yes.
2. Are you located in New York City or Tennessee where S corporation tax rates are egregious and suck up all the federal tax savings? New Hampshire? Portland, Oregon? Say no. Although there might be exceptions where an S Corp makes sense in NYC, TN, and NH in order to maximize Section 199A deduction benefits.
3. Do you have other W-2 income that exceeds or comes close to exceeding the Social Security limits of $168,600 (2024)? Say no. If you say yes, we need net business income to exceed $200,000 in #1 above so that the Medicare savings exceeds the “lost” Social Security tax paid by the S Corp (huh? We can explain).
4. Is this a going concern? In other words, is the business going to continue to earn the same income or more each year? Say yes.
5. Do you have an LLC or some other entity in place that can be elected to be taxed as an S Corp? Say yes. If you say No, we have options, just not elegant ones such as shelf corporations.
6. Do you have other partners besides a spouse… business partners, that is? Say no. If you say yes, are you currently splitting income based on ownership percentages or some formula? If you say Formula, then we’ll need to explore a multi-entity arrangement.
7. Does your entity own any appreciating assets, such as real estate? Say no. We don’t put appreciating assets into an S corporation. Holding companies own real estate, and operating companies elect S Corp status. Chinese Wall.

Are you still here? Excellent news — read on! You can also complete a PDF version of the above questions, and send them to us for review:

Section 199A deduction, also known as the Qualified Business Income deduction, arises from the Tax Cuts & Jobs Act of 2017. This is a significant tax break for small business owners, but there are rules and limits, of course. We’ve written several articles which outline what is considered a qualified business for the qualified business income deduction, including the dreaded specified service trade or business (SSTB) definitions (which is easily summed up as “any trade or business where the principal asset is the reputation or skill” of the owner). Click on the buttons below for our articles:

S corporations remain a critical tax saving tool for two reasons. First, the usual self-employment tax savings remain intact for all business owners, including specified service trades or businesses. Second, a business owner might need to pay W-2 wages to himself or herself to avoid being limited by income, and only corporations can pay W-2 wages to owners (in other words, an LLC cannot without an S Corp election). Read the articles above for riveting information, including W-2 optimization and reasonable shareholder salary.

How does all this work? Good question! To take an entity and have it be taxed as an S corporation by the IRS and your state, paperwork must be completed and submitted. For the IRS, Form 2553 is the necessary form, and it is typically due within 75 days of the fiscal year of the entity or within 75 days of inception. What if it’s summer, and you realized your dog ate your S Corp election paperwork? No worries! In classic IRS fashion, there is one rule and about a hundred exceptions, and Form 2553 is no different. There are provisions for a late S corporation election. We can help.

Back to the issue! Form 2553 is signed in wet ink (the IRS does not accept Adobesign or Docusign or any of those online signature apps) and then either faxed or mailed. We prefer fax. In about 10-12 weeks, you’ll get an S Corp election acceptance letter. Done! If the IRS screws up the effective date, we can fix that too. Remember, they are humans, and can fat-finger a number like anyone else.

Does an S corporation make sense for you? Tired of paying self employment taxes? Can you go back in time for a late S corp election? The answer is usually Yes, but should you? We’ll play the classic accountant and say, “it depends.” But! The decision tree is fairly straightforward. Let’s chat!

Form 2553 (the S Corp election form) must be filed with the IRS. It’s typically due within 75 days of forming your business entity or the fiscal year start (such as January 1), however, there is relief for the late filing of Form 2553, and we can guide you through that. IRS Revenue Procedures 2003-43 and 2004-48 used to be the governing rules, but the IRS has simplified it (imagine that!) with Revenue Procedure 2013-30. We have an entire webpage dedicated to the late S Corp election. We can go back to January of the previous year! Yeah, baby! Check it out here:

Common S Corp candidates and current clients for WCG (formerly Watson CPA Group) are consultants, engineers, financial advisors, physicians, chiropractors, doctors, surgeons, anesthesiologists, nurse anesthetists, insurance agents, attorneys, photographers (the profitable ones), online retailers, FBA retailers, real estate agents, good old-fashioned widget makers, among several others. We also have many medical groups and financial advisor teams. Yes, even those deemed to be specified service trades or businesses still benefit with Section 199A coupled with an S Corp election!

Now that you can save thousands of dollars in self-employment taxes with an S Corp election, you should invest that wisely. WCG (formerly Watson CPA Group) is a small business too, and we understand that any extra dollars usually get invested back into the growing company. Having said that, there are several small business retirement plans which include solo 401k plans, profit sharing plans, cash balance and defined benefits pensions.

For example, with a solo 401k plan piggybacked with a defined benefits pension, you could sock away over $192,000 at age 50. All tax deferred if you like, which could yield a tax deferral savings of over $86,000 (assuming a 45% marginal tax rate with federal and state). Wow!

Note how we purposely did not mention SEP IRAs. These are old school and are typically designed to be crisis management tools (after the fact) rather than good planning tools. Read more about the various self-employed retirement options, including retirement tax bombs and the difference between tax deferral and tax savings below:

Please contact us today to review your particular situation and see if electing S Corp status makes dollars and sense! All the cool kids are doing it- well, most, and we’ll have to ask several questions to make sure the fit is right.