Should I Choose to Tax My LLC as a S-Corp?

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When is a good time to be taxed as an S-Corp?

Do you remember when you started? I remember hanging my first shingle in early 2009… I set myself up as an S-corp and had my Jerry McGuire moment.  I said, “I’m starting my own practice, who’s coming with me“!?  Just like in the movie it was just me.  When I met with an accountant a year later she told me “well you kind of put the cart in front of the horse by organizing as an S-corp.”  At that time I had no clue what she meant.  With hindsight she was right.

My accountant initially said you put the “cart in front of the horse” because I wasn’t making enough money when I started… most people don’t. If you start out as a sole proprietor (or a single member LLC) then you’ll only have one set of tax returns… your personal taxes with the addition of schedule C & E (because you have self employment income).  Until you make money, remaining a sole proprietor is probably a prudent play because you don’t have to pay to register a business name with the state, file articles of incorporation, pay someone to write corporate by-laws, apply for your EIN and various tax ID numbers with the state & city… it’s costly and enough admin work to consume a few days every year.

Turning the Corner, So You’re Showing A Profit!

Let’s say that you do start making money and you’re even showing a profit after a few years! You’re paying for office space, upgrading equipment, purchasing advertising, and doing things you wouldn’t have thought of  a few years ago. Then you hear about S corporations and wonder, “why should I start taxing yourself as an S-corporation?!”  Well, besides the mindset that you have 2 separate sets of books and that you transform into “You Incorporated“, you could save quite a bit on self employment taxes.  Simply put, if you’re business revenue is decent ($80,000 and up for a sole proprietor), you might want to look at being taxed as a S-corp.

An easy rule of thumb for most people is… if I hired someone to do what I do (with my current revenue), what would I pay them? If you would pay them less then your GROSS receipts you use to calculate self employment taxes (i.e. FICA)… then it may be time to convert into a S-corp.  If you become a S-corp (or an LLC taxed as an S-corp), you create a company which you own… then you hire yourself as an employee. In tax terms, you trade your Schedule C for a K-1.

When your company (or any company) pays you $10,000 in wages, 7.65% is withheld from your pay check for the employee’s portion of payroll taxes (6.2% Social Security and 1.45% Medicare). Your company must also pay 7.65% for a combined percentage of 15.3% for FICA taxes. Adding on 25% in income tax equates to a 40% tax rate… yuck!

When you’re “self employed”, a $10,000 of “income” costs you $1,530 in FICA taxes (15.3%).  With an S-corp, you pay yourself “wages” which you still pay FICA taxes for, but then you also pay yourself in “profits” or “distributions” or “nontaxable dividends”. All words for the same thing, money that you give yourself from the company that you don’t pay FICA taxes for. However, your S Corp officer compensation needs to be reasonable. IF you are in a service industry… (i.e. you trade your services/expertise as a consultant, real estate or insurance agent, consultant, investment advisor, health care specialist, software developer, etc…) this usually amounts to 40-50% of income that would be paid as WAGES.  The rest can be sweet sweet distributions that have more favorable tax treatment.

Jumping the Gun

My first year in business I paid myself $7000 that year, and paid my accountant $500 to do my taxes… and looking back on it now she was doing me a favor.  Despite gross revenues of about $40,000… I could only pay myself $7000 after fixed expenses. Back then I thought, all businesses must have an office, separate work computer, a proper website, and those fees and service costs added up.  That’s when my accountant said, “well ya kind of put the cart before the horse.” Yep.

The following year was a nice turn, I ended the year with $83,921 in gross receipts and paid myself $38,719 in W-2 wages.  That year I reported $4,947 in profits! That’s $4,947 I didn’t pay self employment taxes on… or $756.89!  Yay me! I saved money! Not so fast…

It took me another year before I think I grasped this… but there is something called unemployment tax… which you have to pay when you begin paying yourself wages (i.e. as an S-corp). You do NOT pay unemployment taxes if you are a regular “self employed person” not paying yourself W2 wages.

For the first $7000 in wages you pay yourself… your company (that you didn’t have as a Sole Proprietor) pays a 6% tax for the federal unemployment tax or “FUTA”. That’s $420 in taxes that I just never even thought about! My $756.89 tax savings from “profits” was really only $336.89. Nothing to write home about… (NOTE: Most very small employers pay state unemployment tax so the actual overall taxes paid for unemployment is lower than $420 per employee as FUTA drops to 0.6% with the other 5.4% awarded as a credit for paying state unemployment tax.)

What to Do?

If you’re in that $80-$100K gross receipts range, then hopefully business keeps getting better so eventually your wages all but “cap out” and more of each additional dollar turns into profits.  Then you’ll be reporting $20,000 in profits… or a $3,060 FICA savings per year!  That $300-$420 in unemployment taxes doesn’t seem like such a drag anymore!  If you’re in a service industry and gross more than $100K a year, I’d highly recommend looking into being taxed as an S-corp if you aren’t currently doing so.  These tax calculations change as your income grows and you may even hit the FICA tax maximums.

Also don’t forget about new 199A pass through tax deductions!  You’ll receive a 20% federal tax break on your “profits” (for most industries)! If you intend to maximize “profits”… an S-corp can be a good way to benefit from that strategy. There’s some other factors down the line that you’ll want to have awareness of… like in Philadelphia the business income & receipts tax along with the net profits tax vs. school income tax that’ll lower your marginal profits as you declare more “profits”. Nothing huge, but a tax drag nonetheless.

But chances are if you are here and paying full price for health insurance on the individual marketplace, thinking about being taxed as an S-Corp should be on your radar because you’re making money! Well done, keep going & growing! Working with us is a way to test drive the S-corp vehicle as the wages you pay through Fellow Travelers is much like how it would be if you were an S-corp.  Plus, if you’ll save money on health insurance, take that into consideration as well!

P.S. THIS does not apply if you live in New York City!  They tax S Corporations as C Corps and the corporate tax eliminates any advantages about what I wrote above.

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