As a small business owner, you’ve probably heard a little buzz around what the tax classification S Corporation (S Corp) could do for you and your business entity. There are certainly some benefits to consider when making the decision whether to elect S Corp tax status for your business entity. From no double taxation to the ease of ownership transfer, let’s discuss these potential benefits and whether an S Corp election may be in your best interest.
What is an S Corp?
An S corporation (S Corp) is a small business corporation. A common misconception is that an S Corp is a business legal entity like a sole proprietorship, partnership, limited liability company (LLC), or corporation (C Corp). In fact, it is not. An S Corp is a tax classification. For federal purposes, an election is made with the Internal Revenue Service (IRS) to be treated as a “pass-through” entity. Generally, the profits flow through to the owners, and the income (or loss) is reported on their individual tax return. S Corps are not subject to the corporate income tax, meaning they do not experience the double taxation of a normal corporation. We will discuss this in greater detail below.
Schedule C Vs. Schedule K-1
A sole proprietorship owner must file a Schedule C with their Individual Income Tax Return (Form 1040). The profit or loss of a company is reported on their Schedule C. The net income of the sole proprietorship would be subject to tax at the individual’s ordinary income tax rate and subject to self-employment taxes.
On the other hand, an S Corp must file an income tax return for an S Corporation (Form 1120S). The business tax return is due by the 15th day of the third month following the end of the tax year (March 15 for most filers). Each shareholder will receive a Schedule K-1 which is used to report several items such as income, losses, and distributions that will be specific to each shareholder. The Schedule K-1 is included with the individual’s personal tax return (Form 1040).
You are probably wondering what the benefits of switching your business from a sole proprietorship to an S Corp are. Let’s talk about the advantages!
No Double Taxation
Unlike a sole proprietorship, an S corporation is recognized as a separate and distinct entity from its shareholders for tax purposes. However, S corporations avoid the double taxation of regular corporations (C Corps).
Double taxation is when a corporation is technically taxed twice—when the corporation earns income and when it distributes dividends to shareholders who must then report the income on their personal tax return. Even though an S corporation has a separate business tax return, it is an informational tax return. The S corporation business tax return doesn’t have a tax liability but instead generates a Schedule K-1 for each owner to report the income (or loss) on their personal return, which avoids double taxation. As such, it earns the name “pass-through” entity.
Transfer of Ownership
An S corporation can be transferred without complicated accounting rules or adverse tax consequences. Plus, the business will continue to exist after the owner leaves, retires, or dies.
A shareholder of an S Corp is an employee of the business and must be paid a reasonable salary. This means you—your wages would be subject to Social Security and Medicare taxes, but the advantage is that you only pay FICA payroll tax on your salary. The remaining profits of your business are not subject to self-employment tax or payroll taxes but instead just income taxes.
Example: If your S Corp makes $100,000 and you take a “reasonable salary” of $60,000, then the other $40,000 is considered profit. You’ll pay Social Security and Medicare payroll taxes at 15.3% (which is the same amount as self-employment taxes), but you only pay on the $60,000 instead of the entire $100,000 of earnings. The remaining $40,000 is only subject to income taxes. The self-employment tax savings are one of the biggest perks of going S Corp for most business owners.
What is a “reasonable salary?”
There are several factors to consider when determining what is reasonable for a shareholder’s salary. Here is a list of factors that may help you. However, best practice is to consult with your tax advisor.
- Employee’s qualifications
- The nature, extent, and scope of the work being performed
- Size and complexity of the business
- Comparison of salaries with the gross and net income of the business
- General economic conditions
- Rates of compensation for similar positions
- Salary compared to other current employees
- Amount paid to an individual employee in former years
How to Convert a Sole Proprietorship to an S Corporation
- Schedule a call with a tax director to discuss the S Corp process and determine if it’s the best fit for your business.
- Establish your business as an LLC (if it isn’t already)
- Apply for any licenses/permits and pay any taxes or fees (this varies by state)
- Attain a federal Employer Identification Number (EIN) to identify your business entity which you will use to open your business bank account and establish payroll accounts. You will also need it to fill out the forms for taxation, payroll taxes, and corporate records.
- File Form 2553 (S Corp election form) with the IRS by March 15
- Establish an S Corp Accountable Plan. An accountable plan follows IRS regulations for reimbursing workers for business expenses in which reimbursement is not counted as income (home office, mileage, business use of a cell phone, etc.). Reimbursements are not subject to withholding taxes or W-2 reporting. For more information regarding accountable plans, please see this blog from Kitces.com.
Things to Keep in Mind
S Corps require certain protocols to be followed. You must have under 100 shareholders, and there are limitations as to who (or what) entities qualify to be shareholders. Also, you are required to pay yourself a “reasonable salary” and must remit payroll taxes. Generally, bookkeeping and payroll services would be additional costs for your business. You would also need to file quarterly and annual payroll tax reports as well as provide W-2’s for employees (even if you are the only employee).
A word of caution: If the IRS does not determine your salary to be reasonable, they can revoke your S Corp election status, which would revert your business back to a Schedule C, and all net income would be subject to self-employment taxes.
Sign Me Up!
If you are considering switching your tax classification from a sole proprietorship to an S Corp, there are a few things you should understand. First, you have two and a half months from the start of the year to elect for S Corp status. That means March 15, 2022, is the deadline to timely file for S Corp status for 2022. While the tax advantages of an S Corp seem beneficial, each state treats S corporations differently. It’s important to fully understand the implications of an S Corp in your state and on your business before deciding. Schedule a call with the XY Tax Solutions team to determine if it’s the right fit for your business!
About the Authors
Dan Ritter Jr, CPA, is a Tax Manager for XY Tax Solutions. He brings with him over five years of tax experience and holds a Master of Professional Accountancy from Montana State University. Dan specializes in tax for individuals and small businesses and enjoys helping new and established business owners navigate the world of tax and its benefits. Outside of work, he enjoys camping, fishing, and spending time with his wife and four children.
Alli Whittle is a Tax Intern for XY Tax Solutions. Alli's favorite part about her job is working alongside her rockstar teammates on Team XYTS. The positive environment these tax experts cultivate every day makes it a pleasure to show up for work—even on Mondays. In her free time, you can often find Alli reading personal development books or binge-watching Netflix with her family, including her two kids, Emma and Jamie.
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