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By Jason Watson, CPA
Posted Wednesday, October 18, 2023
This book is mostly about S corporations so we saved the best for last. The benefits of an S corporation election include-
- A low audit rate of 0.4% as compared to perhaps 3-5% (yawn)
- Allowing wages to be paid to the business owner to combat the Section 199A qualified business income deduction phaseout (more on that in a bit), and
- The reduction of self-employment taxes (the big elephant).
Read that again. There is very little difference between a garden-variety LLC and an LLC with an S corporation election from an income tax perspective; the savings of an S Corp is from the reduction of self-employment taxes which comprise of Social Security and Medicare.
Recall that Social Security taxes stop at $168,600 (for the 2024 tax year) but Medicare continues into perpetuity. Don’t laugh! That 3.8% Medicare tax times a zillion dollars is a lot of money.
Spoiler Alert: At $2M in net income after expenses (profit), your S Corp tax savings is still above $60,000 even with a $400,000 salary… all because of Medicare taxes.
Other payroll taxes such as Unemployment, State Disability Insurance (SDA), etc. actually increase by electing S Corp taxation, but they are minor compared to the reduction of Social Security and Medicare (self-employment) taxes.
As mentioned earlier, S corporations are pass-through entities and therefore do not pay federal income taxes directly. However, various states might have different taxes such as a business or franchise tax. Additionally, the shareholders only pay Social Security and Medicare taxes on their salaries, yet do not pay these taxes on the net income after expenses (and shareholder salaries) from an S Corp.
Therefore, you would want a tiny salary and a large distribution from the net income, right? Well, sure, but there is a small little IRS rule called “reasonable shareholder salaries” that we spend an entire chapter on. We’ll also show in a later chapter that S corporations have various sweet spots in terms of income versus payroll tax savings from $30,000 to $2 million, between sole proprietorships, LLCs, partnerships and entities taxed as an S corporation.
S corporations are never formed contrary to popular belief. They are spawned from an entity such as a limited liability company, partnership or C corporation that elects to be taxed as an S corporation. After the election is made on Form 2553, you are treated as an S corporation for taxation purposes only. The underlying entity does not change! A lot of business owners rightfully say, “I have an LLC taxed as an S Corp” but they also say, “I have an S Corp.” Technically the former is more accurate, but both get the point across.
Oddly enough, the equity section in your balance sheet should then have a Capital Stock account and an Additional Paid-In Capital account. Again, while your underlying entity might be an LLC without stock (LLCs have interest not shares), it is being taxed as an S corporation so the balance sheet and tax return should look like a corporation. Yeah, it seems weird to have equity accounts that are for corporations while the underlying entity is a limited liability company. However, this coincides with representing the entity as a corporation for tax purposes, yet the underlying governance might be different. This is the whole S Corp vs LLC conundrum.
We can help with the journal entry to populate these accounts correctly so your equity section resembles that of a corporation. This also helps the tracking of basis in your S corporation. A later chapter has some examples.
To reiterate, you are in a weird limbo with electing to be taxed as an S corporation. You need to walk and talk like a corporation for taxes, but the underlying entity and what the Secretary of State will have on file is going to be an LLC, partnership or C corporation. More on the election, and the behind-the-scenes stuff in a later chapter plus our thoughts on corporate governance such as Meetings and Minutes.
Again, this book is mostly about S Corps. The last couple of pages were a slamma-jamma description of the basics.
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