There are a number of reasons to convert your business to an S Corporation but the most common is to reduce self-employment (SE) taxes.
Any one operating their business as a sole proprietorship or an LLC taxed as a disregarded entity (fancy way of saying sole prop) or even a partnership knows that as their business prospers and profits rise, SE tax will also rise proportionally.
The reason the S Corp pays less tax is easily shown on a tax return but I will attempt to explain. In the sole proprietorship, the entire business profit is subject to ordinary income tax AND SE tax. There is no separation between the business and the owner, they are one and the same.
In the S Corp, a wage must be paid to the owner and there is payroll tax on that wage, which is analogous to the self-employment tax. The benefit of the S Corp is that not all profits are subject to the payroll tax, only the wages paid. The remainder of the profits are taken as a distribution, subject to ordinary income tax but not subject to the SE tax. And the wages are deductible to the corporation, unlike in the sole proprietorship. This avoidance of dual taxation on a large part of the business profit produces a large part of the tax savings of the S Corporation.
We typically see a savings of 5-7% of tax liability with conversion to an S corporation. That is net of additional costs of the S Corporation, such as the additional tax return and payroll costs. Roughly that equates to about $1000 in tax savings for each $20,000 in profits. Other savings are possible through proper tax planning.
So, who should look at a conversion? Generally, it’s anyone making over about $10,000 in profit. You might be an LLC or a partnership or a sole proprietor. Operating as an S Corp is very common for real estate agents, contractors, rental property owners, retail businesses, lawyers, doctors, etc.
There are other benefits to an S Corp as well, such as:
- lower audit probability from the IRS,
- protected assets of the shareholders. Some will say the corporate form of ownership is more robust in asset protection than the LLC because there is a longer record of court actions
- easy transfer of ownership
- pass through taxation
- heightened credibility
- your clients don’t need to provide you with a 1099 for work performed, lessening their liability
The process to convert to an S Corp is well-documented, but confusing. The IRS instructions are long, redundant, conflicting and sometimes not understood by IRS agents. We ‘repair” any number of misfiled conversions each year. The business owner may not be aware that their S business has not been approved as an S Corporation until they try to e-file in a subsequent year and the e-file return is rejected. The e-file error often suggests that the EIN is associated with a C corporation or some other entity. To make matters worse, the IRS often lets the first year slide, then rejects it in future years making the fix more complicated.
Many business owners file for an entity conversion but are left without knowledge of the differences in reporting expenses between an S corporation and a sole proprietorship. The most common error is not paying the owner(s) a ‘reasonable wage’. Reasonable wages must be paid in an S Corp, as described in the IRS instructions for an 1120S ( Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” ). A business owner that doesn’t claim a reasonable wage could see all income subject to SE tax in a subsequent audit (eliminating one of the major benefits of the S Corp conversion). Because of subtleties in the new tax law, the IRS has setup task forces to ensure that reasonable wage rules are followed so this has become more important in proper operation of your S corporation.
Also, some there are a number of deductions that must be reported differently if filing as an S corp, such as the home office or health insurance premium deductions and a number of other expenses. Claiming these deductions incorrectly will invalidate them in an audit.
So, it may sound complicated but we help simplify it. If you think you might be eligible for S Corp status, we can help you determine that with a quick review of your business situation. Consultations of 1 hour or less, which is typically all we need, are free of charge. It may not be too late to change your 2019 entity to an S Corp.
Give us a call. You may end up with a few thousand extra dollars in your pocket this year. Every one of the conversions we have completed are enjoying those tax savings, year-after-year.
Aurora Financial Services