S Corp Election Self Employment Tax Savings
Posted Mon, June 1, 2020
There is 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
- 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 is 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) since the IRS and most states consider a SMLLC to be a disregarded entity for taxation, and both a sole proprietorship and a SMLLC 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 is not an entity. It is a taxation election. The underlying entity has to be one of the above, and usually it is 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 biggie if you thought otherwise. Many people do!
Avoid Self-Employment Taxes
A common complaint from those who own their own business is 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.
If you own a business as a garden variety single-member LLC (one owner), your business income will be reported on your personal tax return 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 has not 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 is 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.
S Corp Election
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.
|Income||Total SE Tax||Salary||Total Payroll Tax||Delta||Delta%|
Don’t get too hung up on the drop in percentages. 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 are 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 continues 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!
Section 199A Pass Thru Tax Reform
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 have 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 remains 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 not be 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.
S Corp Election Money Trail
So, when your partnership, LLC or corporation is being taxed as an S Corp you are both an employee and a shareholder (think investor). As an employee, your income is subjected to all the usual taxes that you would see on a paystub- federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment taxes and disability insurance (state specific). However, as a shareholder or investor, you are 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 is 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.
And when we say self-employment taxes, we are 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!).
So an S Corp doesn’t pay taxes per se since it is 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-
S Corp Election Process
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 is 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.
S Corp Election Consultation
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? We’ll play the classic accountant and say, “it depends.” But! The decision tree is fairly straightforward. Let’s chat!
Late S Corp Election, Oops
Form 2553 (the S Corp election form) must be filed with the IRS. It is typically due within 75 days of forming your business entity or the fiscal year start (such as Jan 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-
Business Advisory Service Plans
WCG specializes in small businesses who generally have fewer than 100 employees. Why? We want to help people, and more importantly we want to help the business owner directly. Frankly speaking, once a business gets to a certain size management layers get in the way of owner access. Access allows us to ensure the owner(s) are leveraging the most out of their business for themselves and their families.
Because small business is a core competency for us, we have created business advisory service plans which include these really cool things-
|A la Carte*||Vail||Telluride||Aspen|
2023 Tax Planning and Preparation
|Streamlined Tax Planning, Tax Projection Worksheets||$350 to $500|
|Annual Tax Reduction, Shifting and Deferral Analysis||$350 to $500|
|Small Business Tax Deductions Optimization||Included|
|Section 199A QBI Deduction Tax and Salary Optimization||$300|
|Estimated Income Taxes (via increased payroll withholdings)||Included|
|Business Entity Tax Return (Form 1065, 1120, 1120S)||$1,500 starting|
|Individual Tax Return (Form 1040, joint filing), One Owner||$800 starting|
|Expat / Foreign Income Calcs (Form 2555, FBAR, Form 8938)||$300 to $500||Add-On||Add-On||Add-On|
|Tax Resolution, Audit Defense||Varies||As Req'd||As Req'd||As Req'd|
|Financial Planning, Calculations, Discussions||$900 to $2,500||Add-On||Add-On|
|Situational Tax Law Research (up to 3 hours annually)||$750 to $1,000|
Payroll and Accounting Services
|Reasonable Shareholder Salary Calculation (RCReports)||$500|
|Monthly Shareholder Payroll Processing (up to 3 shareholders)||$1,200|
|Employee Payroll Processing (bi-weekly, direct deposit)||Varies||Add-On||Add-On||Add-On|
|Annual Payroll Processing (W-2s, other filings, up to ten 1099s)||Included|
|Accounting Services (bookkeeping + analysis... see below)||Varies||Add-On||Add-On||Add-On|
|Quarterly QuickBooks Consulting (QuickStart Launch)||$250, $750||Add-On|
Business Advisory Services
|Business Consultation, Periodic Business Reviews (PBR)||$250 to $1,000||Annually||Routine||Routine|
|Complimentary Quick Chats (CQC)||$250 to $500||Routine||Routine||Routine|
|CPA Concierge Services||Varies||Add-On||Add-On|
|Interfacing with Lenders, Attorneys, Financial Planners||$750||Routine||Routine|
|Fractional Controller (monitoring 3rd party bookkeeping)||Varies||Add-On||Add-On||Routine|
|Quarterly Financial Statements Analysis, Comparisons||$1,200|
|Annual Cash Flow Management and Analysis||$1,500 to $2,500|
|Annual Budgeting, Forecasting, Goal Setting||$750 to $1,000|
|Annual First Research Reports, Industry-Focused Consulting||$350 to $600|
|Annual National and Metro Economic Reports||$150|
|KPI Analysis, Benchmarking, Hot Sheets, Trend Analysis||$500 to $1,500|
|Strategy and Maintenance|
|C-Level Financial Advice, Strategic Planning (Fractional CFO)||Varies|
|Succession Planning, Ownership Changes Consultation||$750 to $1,000||Routine|
|Annual Business Valuation||$2,500 to $3,000|
|Annual Corporate Governance, Resolutions, Meetings||$150 + filing fee|
|(prorated based on onboarding date)|
Custom! Unlike the modern day new car packages where you have to spend $8,000 for the moonroof, our Business Advisory Service plans can be customized specifically for you. The array above is simply a starting point. If you need more or less from us, let’s chat about it!
Tax Patrol Services
We also have Tax Patrol! This is a wonderful tax service for those who don’t need all the business advisory bells and whistles above, but from time to time want some love from an experienced tax consultant and business advisor. Have a quick tax question? Need to know the depreciation rules as you buy that new car? Wondering what your April tax bill is going to be in August? Tax Patrol is like ski patrol… you might not use it, but you sleep better knowing you have it.
|A la Carte*||Keystone||Copper||Breck|
|Individual Tax Return Prep (Form 1040, joint filing)||$800 starting|
|Business Entity Tax Return Prep (Form 1065, 1120, 1120S)||$1,500 starting|
|Streamlined Tax Planning, Tax Projection Worksheets||$350 to $500|
|Estimated Tax Payments Calcs||Included|
|Tax Resolution, Audit Defense||NA||Add-On||Add-On||Add-On|
|Complimentary Quick Chats (CQC)||$250 to $500||Routine||Routine||Routine|
|(prorated based on onboarding date)|
Additional Business Services
The following are additional business services to get your venture launched and on the way. Some of these are teased out separately as one and done fees like formation and onboarding stuff.
|Monthly Accounting (bookkeeping + analysis)||starting at $400 / month|
|Bi-Monthly Accounting (bookkeeping + analysis every 2 months)||starting at $250 / month|
|QuadMonth Accounting (bookkeeping + analysis every 4 months)||starting at $175 / month|
|Sales Tax, Personal Property Tax||typically $75 / month, $150 / quarter|
|Employee Payroll (direct deposit, bi-weekly)||1 employee, $100 / month
2-5 employees, $175 / month
|Fine Print: Accounting fees are based on 2 bank account with less than 250 monthly transactions but does not include the QBO fee from Intuit. Custom quote is available if you have a lot going on such as third-party integrations (POS, time billing system), accrual accounting method, extensive benefits packages and / or industry specific issues (e.g, job costing in construction).
Even Finer Print: Employee payroll can be added only if already using our Business Advisory Service plans above (e.g, Vail). Custom quote for more than 5 employees and a referral to therapy.
|Articles of Organization or Incorporation, Domestic Owners||$425 + state filing fee|
|Articles of Organization or Incorporation, Foreign Owners||$725 + state filing fee|
|Initial Report (if required)||$125 + state filing fee|
|Employer Identification Number (EIN)||Included|
|Single Member Operating Agreement (SMLLC)||Included|
|MS Word Templated Bylaws Agreement (Corporations)||Included|
|S Corp Election, Timely Election (made with formation)||Included|
|Payroll Accounts Setup or Transfer||$425 to $550 depending on state|
|Employee Data Transfer||$25 per EE, >5|
|Accounting Setup or Transfer (Fractional Controller)||Varies|
|QuickStart QuickBooks Setup and Support (90 days)||$750|
|S Corp Election, Timely Election (within 75 days)||$450|
|Late S Corp Election Back to January 2022||$600, $1,200 after Jan 1 2023|
|Examine Prior Tax Returns||Included|
|Moving Entity to New State||$750 + state filing fees|
|Closing Payroll Accounts||$350|
|Address Changes w/o Payroll||$350 + state filing fees|
|Address Changes with Payroll||$450 to $600 + state filing fees|
|Address changes are tough. Basic address changes require IRS, State Department of Revenue and Secretary of State notifications. Address changes that include payroll add another level of complexity since departments of revenue are not the same as departments of labor, and there might be local or municipal agencies as well.|
Advisory Services Fine Print
A la CarteA la Carte fee ranges are approximates. 85% of our clients fit into these fee ranges, but there are outliers. We have a handful of clients with over 30 rentals; their individual tax return is north of $4,000. We also are assuming one state; if your business spans the galaxy then additional fees will be discussed with you prior to payroll setup or tax preparation. Typically each state or tax jurisdiction is around $250 to $350 for tax preparation since it affects both your business and individual tax returns (frankly, state apportionment is a pain in the butt, but it is our pain… and states, especially California and New York, are crazy about it).
Some more things to consider- when a partial year remains, our usual annual fee is pro-rated to not charge you for services you didn’t use (like payroll and consultation). However, a large chunk of our annual fee is tax preparation which is typically a built-in fixed amount of $2,300 (both business entity and individual tax returns) plus annual tax planning. Whether we onboard you in January, July or December, we have to prepare a full year tax return. This increases the monthly fee for the remaining months of 2023 but the monthly fee will later decrease in January of 2024 to reflect the amounts above. Yeah, we make it sound like 2024 is just around the corner.
We make very little profits on payroll processing… we offer it as a convenience to our clients. One throat to choke with a single call can be reassuring but if you want to run your payroll, go for it! Everyone thinks payroll is a piece of cake; write a check and done. Nope… we see a lot of mistakes being made by clients especially the handling of health insurance and HSA contributions since there are special rules for greater than 2% S Corp shareholders. Then again, we don’t mind fixing what was broken.
You can prepare your own individual tax return as well… but the benefit WCG preparing both individual and business tax returns is that we slide things around depending on income limitations, phaseouts, alternative minimum tax (AMT), Section 199A deduction optimization, pass-through entity tax deductions (PTET), etc. Having our arms around both can yield some good tax savings!
Note: An individual tax return is what the IRS calls Form 1040 and refers to the entity filing the tax return (you, the individual, are the entity). However, a married couple are deemed to be one entity for the sake of an individual tax return. So, when we say we will prepare your individual tax return, it is meant to include your spouse in a jointly filed tax return.
Break-Even Analysis (does an S Corp make sense?)
Break-even analysis is based on our annual fee of $4,440. If an S corporation saves you 8% to 10% (on average) in taxes over the garden-variety LLC, then $4,440 divided by 9% equals $50,000 of net ordinary business income (profit) after expenses and deductions.
More sales pitch! Keep in mind that our fee of $4,440 includes your individual tax return which you might already be paying another tax professional to prepare. WCG has a handful of clients who are right at the break-even point of $50,000 but leverage an S Corp and our services to get tax preparation, tax planning and consultation.
We are not salespeople. We are not putting lipstick on a pig, and trying to convince you to love it, even if Tom Ford’s Wild Ginger looks amazing. Our job remains being professionally detached, giving you information and letting you decide.
We see far too many crazy schemes and half-baked ideas from attorneys and wealth managers. In some cases, they are good ideas. In most cases, all the entities, layering and mixed ownership is only the illusion of precision. Just because you can complicate the crap out of your life doesn’t mean you must. Just like Chris Rock says, just because you can drive your car with your feet doesn’t make it a good idea.
Here is a brief summary of the next steps should you want to engage WCG with Business Advisory Services or Tax Patrol-
1. We schedule an appointment to discuss your needs and ensure that we have the proper resources to help you.
2. We draft a proposal outlining the scope of services and our fixed annual fee.
3. If necessary, we schedule another appointment to review the proposal and perhaps tighten things up or make changes.
4. Once the proposal is signed, the fun begins with onboarding. We have an extensive checklist and internal task list to properly onboard you and your business. Some things are concurrent (such as gathering housekeeping docs and setting up payroll) and some things are sequential (for example, collecting financial data and then offering salary recommendations and creating a tax plan). Onboarding is like having a baby; a SWAT team shows up and does a zillion things, and poof, everyone is gone except for mom and baby.
5. After onboarding (usually 4-6 weeks), things settle down into a rhythm- Tax preparation in the spring, tax planning in the summer, with payroll and routine consultation bouncing along throughout the year.
Our Business Expertise
As mentioned elsewhere we primarily focus on small business owners and their unique consultation and tax preparation needs. With over 40 full-time consultation professionals including Certified Public Accountants, Enrolled Agents and Certified Financial Planners on your team, WCG consults on custom business structures, multiple entity arrangements, S corp elections (even late S corp elections back to January), tax strategies, business coaching, industry analysis, executive benefits, retirement planning including individual 401k plans, exit strategies, business valuations, income tax planning and modeling, and tax representation.
We also work with business law attorneys for business owners who have additional needs such as drafting Operating Agreements, fee for service contracts, buying or selling a business including employee stock ownership plans and partner buy-ins. In addition, WCG coordinates with third party plan administrators such as Polycomp and RPS to create age-based profit sharing plans and cash balance (defined benefit) plans. We can run point on whatever your business needs to ensure that communication is effective and efficient allowing you to sell widgets.
Here are some additional resources you might find useful.
S Corp Election Checklist
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-
- Does your business earn over $30,000 net income after expenses? Say Yes.
- 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? Say No. Although there might be exceptions where an S Corp makes sense NYC, TN and NH in order to maximize Section 199A deduction benefits.
- Do you have other W-2 income that exceeds or comes close to exceeding the Social Security limits of $137,700 (2020)? 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.
- 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.
- 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.
- 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.
- 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-
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 several 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!
Self Employed 401k Plan
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 usually 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.