Should My Business Elect to be an S Corporation?

This post took entirely too long to get here. Alas, here it is. I have had plenty of people ask me whether switching from a single member LLC to an S Corporation is right for them. The answer will always be “it depends.” There are way too many variables to give a definitive answer in a quick five-minute conversation. The best way to know whether making the switch is right for you is to map out the difference in taxes and other costs between the two entities. For the purposes of this post, I will describe why an S Corporation could be more beneficial…and will add a few reasons why it may not be

Self-Employment Taxes

Let’s start with the big one. If your company converts to an S Corporation, you, as the sole member, become an employee of the company. The great thing about this is that you will no longer have to pay both the employer and employee side of payroll tax (15.3% total) on all your net income on top of your effective income tax rate. Instead, you must pay yourself a reasonable salary before taking any owner’s draw (distributions). This salary, along with the employer half of the related payroll tax, is deductible by the S Corporation, which reduces your net income in comparison to the LLC. This could lead to less taxes being paid overall. An example of this might look something like what you see below:

Qualified Business Income Deduction

Although K-1 income ($46,175) flows through from the S Corporation to you as the shareholder is lower than the LLC as shown above, it is possible that the taxable income, W-2 plus your K-1 income, will be higher than that of the LLC. Why? Well, once you switch to an S Corp and deduct your wages, your net income will be lower and therefore the large 20% qualified business income deduction you received as an LLC will also be much lower. It is possible that the offset in lower QBI deduction will cause some business owners to refrain from switching entity types. In the example below, you can see a visual example of what I mean:

The taxable income to you as an S Corporation member is higher than that of the LLC (50,000 line 1 of your Form 1040 + 36,940 Schedule E income) 86,940 vs $80,000 Schedule C income for the LLC.

Lower Overall Taxes?

It is possible the total amount of taxes you pay will still be lower as an S Corporation because you are only paying the employee side (7.65%) of payroll tax and the effective income tax rate on $86,940 vs 15.3% self-employment tax plus your effective income tax rate on $80,000 (LLC Net Income). Clear as mud? Think of it this way. You are paying 7.65% less on similar income (in this case) if you are a member of an S Corporation. Does it always work out this way? Not necessarily. It is possible that the income for the S Corporation will end up higher due to the large reduction in qualified business income and the savings in taxes cannot negate the decrease in QBI deduction. Is the above a very simplistic example? Absolutely. There are more variables not shown here that can affect these numbers. This is why a calculation tailored to you and your business makes sense before deciding.

Other Considerations

An S Corporation return is not the type of return to attempt to do in TurboTax. It just isn’t. S Corps are far too complex, and most business owners will not be able to understand all the tax rules that govern this type of entity. Therefore, you will need to pay a trained professional to prepare one. There will likely be planning involved and you will need the knowledge of CPA to help you avoid pitfalls. Lastly, there will be cost to use a payroll service which you haven’t had to consider before. The good thing here is that payroll services are not crazy expensive.

Conclusion

It is possible that switching to an S Corporation will benefit you and your business. However, before switching, you should do the leg work and consult with an advisor before you make the election. If you would like to discuss this topic in more detail, please contact us at 571-445-0201 or abs@westhighlandtax.com. We would be happy to create a projection for you or discuss your specific needs.