When starting a small business, there are so many decisions that need to be made. Often, people are so focused on making the business a success, that they want to spend the least amount of time dealing with accounting and administrative work to keep it going. That is why sole proprietorships are so popular when it comes to tax time. You report the income and expenses on Schedule C and pay the tax.
Some decide that they want extra liability protection, so they chose to become a single member LLC. Single member LLCs have become very popular because they give the legal protections like being a corporation, but they are not as cumbersome with restrictions and certain filings as corporations can be. Single member LLCs by default are taxed just like a sole proprietorship.
A lot of small businesses are not aware though that sole proprietorships and single member LLCs not only pay regular income tax but they also have to pay self-employment taxes. SE taxes alone are an extra 15.3% on top of the regular tax rate. This can make the total taxes owed increase significantly as your taxable profit increases. You may ask, is there something I can do about this?
One very popular option is to choose to become taxed as an S Corporation. A sole proprietor can set up a corporation and make the election to be an S Corporation. When you become a single member LLC; you by default get taxed as a sole proprietor or you can elect to be taxed as an S corporation. This election can be made after a single member LLC has been formed.
So, when should you think about changing to an S Corporation? There are a lot of factors to consider in making that decision.
What are some of these factors?
Self-employment tax savings
As discussed above, when you are taxed as a sole proprietor, you pay self-employment taxes. A great advantage of an S corporation over a regular single member LLC or sole proprietor is not having to pay the additional 15.3% of self-employment taxes on the profit.
In an S corporation, the owner takes distributions and a salary from the profits to minimize income tax. The S Corporation files a separate tax return. From that tax return, the shareholder (small business owner) will receive a Form K-1. The Form K-1 reports the taxable profit of the business that you report on your tax return along with any flow through credits and deductions from the business. So you still pay regular tax for the business on its profit, but you do not have to pay SE taxes. So on a taxable profit of $35,000, you can save $5,355 in taxes just by being an S Corporation!
Tax-preferred retirement savings
Being an S Corporation also provides greater flexibility for investing in retirement. S corporations can set up plans like a Solo 401k.
With a Solo 401k, you can contribute up to $18,000 to a Roth Solo 401k. You can also contribute up to another $36,000 to a traditional Solo 401k. A limitation on both of these is that you cannot contribute more than your salary.
When you are being taxed as a sole proprietor, you simply need to keep up with your income and expenses. Some people will throw all of their deposits slips and receipts in a box. On a side note, please don’t throw it all in a box! You are just asking for problems down the road with an audit. You do need to keep track of your income and expenses with backup documents in the event you get audited, but please do so in a very organized manner.
An S Corporation does have to keep a balance sheet along with a profit and loss statement. The balance sheet must be kept up to date throughout the year. Normally, to maintain proper books most companies will need to hire an accounting firm or get a qualified in-house accountant.
Salary and Distributions
One rule of being an S Corporation is that the IRS requires the owner to take a reasonable salary from the profits. Of course, if the business has a loss, you are not required to take a salary out. The salary should be at your particular industry standards and should be supportable. I often recommend that business owners consult with their CPAs to ensure that their salary would meet the IRS’s expectations of reasonable compensation.
An S Corporation is required to keep up to date minute books. While this may seem silly and unnecessary when it is a one owner business, the law still requires it. You have to document major decisions that you must decide as the owner. Failure to keep meeting minutes can allow a court to take away any corporate liability protection. We also highly recommend our clients keep up to date minutes because it is possible that the IRS could conclude you are not acting like a corporation and thus should lose the tax benefits of being a corporation.
It is important to consider the tax law of each state that your business will be taxed in. Some states will tax the business at the S Corporate level in addition to the individual shareholder level. If you incorporate or have nexus in one of those states, the tax savings for switching from LLC to S Corp does diminish but can still be beneficial. Also, for each state that requires a return to be filed, that means you may be required to file an individual return with that state as well.
Should I switch to an S Corporation?
You will want to make the switch when the tax advantages outweigh the increased cost you will incur. If you regularly have less than $25,000 in net income year to year, then the switch would probably not be very beneficial. If your net income is between $25,000 - $50,000 then you would probably benefit, but a lot of the factors would need to be examined to make a final determination. If your net income is over $50,000, then I would recommend that you consider converting to anS Corporation. Your circumstances will determine if the switch is the right choice for you. Even if your situation falls in the middle, you may benefit based on multiple factors. I always advise consulting with a qualified CPA to discuss these factors in detail. We are here to help you to determine if you should switch your sole proprietor business or single member LLC to an S Corporation. We would also love to assist you in filing the necessary forms with the IRS and state. Just remember that each situation is unique and that it is up to you to find out what works best for you and your business!