S corp Tax Benefits & Legal Requirements

The last topic to discuss in our series regarding the benefits of creating a Limited Liability Company (“LLC”) is in regard to taxes.  Specifically, we will look at the tax advantages and legal requirements of an S Corporation in relation to your LLC.

What is an S Corporation?

Forming an LLC creates a legal entity but the LLC itself is not recognized by the Internal Revenue Service as a taxpaying business structure. The owners of an LLC must decide on its identity for tax purposes: a sole proprietorship, a partnership, an S Corporation, or a C Corporation.

An S Corporation is not a business entity type on its own.  An S Corporation can have a number of different business structures, an LLC included.  In essence, not all LLCs can file as an S Corp and not all companies that file taxes as an S Corp are LLCs.

Selecting to file as an S Corp means that income will “pass-through” for federal taxation. This “pass-through” allows for your business income, losses, deductions, and credits to flow directly to your own personal tax return as a shareholder.  Then you pay taxes on that income at your ordinary tax rate.  You do not pay federal taxes at the entity level.

One of the biggest advantages of an S Corp is the fact that you can save on self-employment taxes.  Currently, the self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare).  Filing as an S Corp, you can take an owner’s distribution which is not subject to this self-employment tax rate.  You know the IRS isn’t going to let you take it all as a distribution and not pay any self-employment taxes at all but it can be a significant saving.

Requirements of an S Corporation

In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation with the IRS.  The form must be signed by all the shareholders of the LLC and it must be filed in a timely manner.  In addition, there are certain requirements that need to be met.

One main requirement of an S Corp is that you have to pay yourself a “reasonable” salary. You can’t take everything as an owner’s distribution.  The amount considered as a reasonable salary varies depending on your industry and income from the business. For example, if you're an attorney and your practice makes $300,000 a year but you only paid yourself a salary of $50,000 the IRS is going to say you did not pay yourself a reasonable salary for an attorney based on the amount of income that you made.

The IRS doesn’t want to decide what people should earn, so they provide little guidance to help you determine what is a “reasonable” salary. You should have a good basis as to why you choose the salary you do.  Professional organizations often have data on the average earnings in your industry for your area.

The LLC must also be a domestic corporation.  Foreign corporations do not qualify to file as an S Corp. There are also some types of corporations that are ineligible.  For example, certain financial institutions and insurance companies cannot file as an S Corp.

There has to be less than 100 shareholders and they must be US citizens.  Certain trusts, estates, and tax-exempt organizations can be shareholders but there may not be partnerships, corporations or non-resident alien shareholders. There can only be one class of stocks issued to the shareholders. 

How S Corps Save You Money

I really want to bring home for you how filing as an S Corp can save you money.

Let’s take an example of two landscape designers, David and Maya.  Both businesses have filed as a LLC in their state.  After deductions, each business had the same net profit of $100,000.

Our first designer, David, is filing as a sole proprietor.  He will pay self-employment taxes on all $100,000, an estimated $14,130.  In addition, he will have to pay state and federal income taxes at his normal tax rate. If his normal tax bracket is 21% then he will pay 36.3% taxes on the $100,000 (15.3% self-employment and 21% income tax).

Our second designer, Maya, elected to file as an S Corp.  She is both the sole shareholder and the sole employee of the business.  Maya’s business has the same net profit of $100,000.  However, she paid herself a (reasonable) salary of $40,000. Each time her payroll service issued her a paycheck they removed the taxes for Social Security and Medicare.  By the end of the year, she will have only paid $6,120, a savings of over $8000 from what Mike paid.  At the end of the year, Maya will only pay state and federal income taxes on that $40,000 at her normal tax rate.  She will also still owe income tax on the $60,000 (same as Mike) but she saves.

There are some additional expenses you might incur by becoming an S Corp but these are more than offset by what you save in taxes.  You might want to retain the services of a payroll service to calculate the Social Security and Medicare taxes.  They can automatically transmit the taxes to the state and federal agencies and produce a W-2 at the end of the year.  In addition, there may be unemployment or other benefits like short-term disability the corporation can be required to pay in your area.  All the federal, state, and local payroll forms can get complicated and there can be fees and penalties if you get stuff wrong.  A professional payroll service should be less than $100 a month

You can save quite a significant amount of money by changing to an S Corp.  However, you want to be able to have enough of a regular income to pay yourself that reasonable salary and the dividends.  The benefit of an S Corp becomes more significant as overall net profits increase but don’t discount the savings even as a “small” business. The difference between paying self-employment taxes on a net profit of $50,000 vs. a $20,000 salary/$30,000 dividends can result in a $4,000 a year savings.  This is just an example of the potential differences in taxes.

S Corp and States

Of course, anything dealing with taxes is complicated.  Many businesses do business in multiple states and are required to file income tax returns in them. Different states treat S corporations in various different ways.  The method of selecting S Corp status, the types of taxes assessed, the formulas used to assess the taxes, and what can be excluded from taxable income changes among all the states.  For example, New Hampshire and Tennessee tax S Corps and C Corps the same, there is no flow through, and the corporation must pay income taxes.

Most states follow the S Corp status from the federal election. A few states do require separate election within that state.  There are states that have no income tax and states that add additional taxes on S Corps. Some states allow multi-state composite tax returns on behalf of the shareholders so that the individuals don’t have to file a return in that state.  Some states have estimated tax requirements for S Corps.

In Conclusion

Electing to have your LLC become an S Corp can be very advantageous.  It is a two-step process though.  Step one is to create the LLC, step two is to complete the correct form for the IRS. The Law Office of Alexis Hart McDowell can help you form your S Corp, LLC, C Corp, L3C or 501(c) in any state. Please contact us for your free 15-minute consultation so we can discuss your needs.