If you earn your living as a contractor, you pay self-employment taxes on the profit your company makes. You could be a real estate agent, a builder, a car salesman, whatever. As a contractor, if you don’t pay estimated taxes throughout the year, you’re getting hit with a big tax bill at tax filing time. The more profit you have, the more tax you will pay.
Electing S Corp status can drastically reduce that.
I say you need to start now because you can’t elect S Corp status and save on those taxes unless your business entity is either an LLC or a corporation. If you file for LLC or profit corporation status with the state before the end of the year, then you can chosse S Corp status for 2021.
If you are already an LLC or a profit corporation, you can elect to be taxed as an S corporation when you file your 2020 tax return. S Corp status can become effective back to the date your business became an LLC or a corporation. Theoretically, you can go back 3 years and even amend returns to adopt this status, though issues can arise when using a late election process.
The most common reason for electing the S Corp status is to save on self-employment taxes. There are other reasons which I will elaborate on later but saving taxes is the most common, at least in our practice. Business profits for sole proprietorships, partnerships and LLC’s taxed as either are essentially taxed twice. The owner’s share of profit is added to whatever other income there is on there tax return. This could be spousal wages, dividends, interest, capital gains, etc. You pay ordinary income tax on all of that income (minus whatever deductions and credits you might be eligible for). Then you are assessed a tax again on those business profits. This is the self-employment tax. This is analogous to the payroll tax but that is typically not noticeable to employees as it is deducted from their paycheck throughout the year.
You can have zero ordinary taxable income and still have to pay self-employment tax. As an example, let’s say you are married and your business produces a profit of $24,000. The standard deduction will wipe out that income for ordinary income tax purposes but you will still have to pay self-employment tax on the business income. The SE tax rate works out to be about 14% after deducting half of the SE tax owed.
So, how does an S Corp save you money? The S Corp pays you from your profits with 2 income streams. One is a wage and you will pay a payroll tax on that income. The other is a distribution. Distributions are taxed as ordinary income but are not subject to either the payroll tax or the self-employment tax. You have to pay yourself what the IRS calls a ‘reasonable wage’, which is a topic for another blog, but that reasonable wage often works out to between 1/3 and 1/2 of your profit. Not paying payroll tax or self-employment tax on that distribution is what produces the tax savings. With planning, you can also take advantage of quirks in the tax code that apply to S Corporations to save even more on taxes. The savings we typically see for most businesses works out to at least $1000 for each $20,000 in profit. We have seen as much as $25-$30,000 in tax savings in a single year by converting an existing business to an S Corp.
Other advantages of the S Corp status include:
- 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 liablity
There are disadvantages as well:
- there is an extra tax return to file
- most will have to use a payroll service, with additional costs
- recordkeeping is a bit more demanding if you want to take advantage of some of the S Corps deductions available
- the reduction in self-employment tax could reduce your social security payment (if you are not already collecting), potentially reducing payouts in future retirement years
If a conversion to the S Corp sounds interesting to you, give us a call. We can look at a prior year return and ask a few questions to quickly tell if there would be an advantage for you.
It might be worth a look and you could end up with several thousand extra dollars in your pocket at tax time.