S Corp Election Self-Employment Taxes
S Corp Election
Posted July 22, 2019
There is a misconception floating around out there that an S Corp is a standalone entity. Not true. 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. 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,” 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 or shareholder), 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)-
|Income||Total SE Tax||Salary||Total PR 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 Aspen, Vail and Breckenridge. Yup, we’re from Colorado! Still not sure or not convinced? No problem… please check out Line 57 from Schedule 4 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? 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 2018! Check it out here-
S Corp Package
The Watson CPA Group specializes in S corporations which have a small number of shareholders, and are often just a one-person show. Did you know that 95% of all S Corps have only one shareholder, and 99% of all S Corps have three or fewer shareholders? Because small business is a core competency for us, we have created an S corp package that includes the following (No, the S doesn’t stand for stormtrooper)-