Having an S corporation may give your business preferred tax treatment, but how do you know whether or not changing your business into an S corporation (S corp) will be worth it? We go over the details of the pro and cons of this often misunderstood sub-chapter of the Internal Revenue Code.
S Corporations explained
Every business type is taxed a certain way by default, but sometimes there are other options that you can elect into that will lower your overall tax bill. For example, a LLC is taxed as a sole proprietorship by default. This might not be ideal because all self-employment income is taxed at 15.3% and then the remaining income is taxed at your personal income tax rate.
However, if you elect from your LLC to be taxed as an S corp, you’re going to be able to qualify to have “disregarded entity” status, which essentially means that you are a corporation, but the IRS is not going to tax you as a corporation. You won’t have to pay employment tax on owner distributions.
Tell me more about owner distributions
By creating an S corp you’re saying, “Hey, I’m taking part of this as a wage and then the other part I’m going to take as a distribution from the company.” It’s taxed as an ordinary income on your individual tax return, but it’s treated as a shareholder income, so it’s not going to be subject to self-employment tax.
Let’s say you’re a full-time, self-employed, single-member LLC. Your company, after all your expenses, netted $120,000 and you asked your payroll service to set it up so that every two weeks or every month you’re getting the equivalent of a $75,000 salary annually.
What that means is that on the K-1 (kind of like a 1099 but for distributions) you can now have $45,000 declared as a shareholder income or the distribution that’s not subject to self-employment tax. So all that money was going to get an extra 15.3% on top before you even pay your normal income tax because of the FICA withholdings like Social Security, Medicaid, Medicare, and other programs. So, you’re not having to pay that tax on that $45,000 shareholder income, which is pretty exciting.
If you’re in the 25% income tax bracket and you’re switching from an S corp where someone else was being taxed as an LLC or a sole proprietor, you’re gonna save almost $7,000 on taxes. That’s hardly an insignificant amount.
S Corps mean more paperwork
The S corp has to have a separate tax return. So, if you’re having a CPA do it, just keep the additional costs in mind. Also, if you do your taxes yourself like I do, know that there will be a lot of additional work.
Basically, you will either have additional work or additional costs for this additional corporate tax filing. That tax filing is due March fifteenth.
Shareholder’s share of income: Schedule K-1
An S corp tax filing is different than the personal income tax filing, so you’re also going to be filling out K-1s. If you’re just a business owner with no employees, you will need to send that tax return off on March 15, fill out a schedule K-1, give yourself the schedule K-1, and then that’s going to show up on your personal income tax return.
Payroll tax filings: 940
If you have a payroll service, they’re going to file this 940 for you.
Quarterly S tax filings
You have to submit a 941 every quarter that tells the IRS the amount of money withheld. You can look at the forms and instructions on the IRS website.
Most people who are start their own business full-time or on the side didn’t start it because they were wildly passionate about bookkeeping or accounting. They did it because they like programming or designing or UX—making cool things and really seeing their projects out there in the world. So honestly, with the pricing of a payroll service like Gusto, it makes a lot of sense to get a payroll service to take care of all of that for you so you can focus on your passion.
Personal tax filings
Schedule K-1 earnings show up on your Schedule E
Now you’re going to have income show up on your schedule E from your K-1 and this is your distribution. You still have the W-2 wages and those are going to be reported as normal, like you would for any other income tax return.
When applicable, use Form 1040-ES to estimate quarterly tax payments.
If you’re starting a new business and seeing a significant increase in income, you might want to think about maybe setting up quarterly estimated payments. The IRS isn’t super happy about really big swings from year to year in terms of how much you pay versus how much you owe, so you will want to think about that as well. If you have a CPA, they can do that for you.
ZipBooks provides online bookkeeping services
ZipBooks provides online bookkeeping, tax, and payroll services. If you think you could gain a lot of tax savings from making the switch to an S corp but aren’t excited about taking on the additional paperwork, we can do the paperwork for you and you’ll come out thousands of dollars ahead.
For more detailed examples on how an S Corp might benefit you, take a look at the more in-depth treatment I give the subject here.