Starting A Business Series Part 3: The Magic of the S Corp Election
Earlier in this series, we discussed the differences between the most common entity types: sole proprietorship, general partnership, limited liability company, and corporation. We learned that the most important differences are related to liability protection and tax treatment.
In this post, we will zoom in on the s-corp election and why it can save small businesses so much money.
S-corp is a federal tax election. It is not an entity type. The s-corp election is available to both corporations and limited liability companies. Pretty much all small corporations choose the s-corp election because they are subject to double taxation at the entity level if they do not.
For limited liability companies, the s-corp election is not so obvious. In my first year of law practice, I had to learn this the hard way when I overpaid more than $10,000 in taxes that I will never get back from the federal government - all because I did not know about the wonders of the s-corp election.
Normally, the owner of the LLC must pay self-employment tax (which is currently about 15.3%) to the federal government on every dollar of salary that is paid to the owner. All of the payments from the owner to themselves up to $137,700 (in 2020) are subject to this self-employment tax. That means that if you pay yourself $100,000 in a calendar year, you would owe another $15,300 in self-employment taxes to the federal government.
On the other hand, if your business is eligible to elect s-corp status, you will divide the money that you pay yourself into 2 groups: a reasonable salary, which is subject to the 15.3% self-employment tax, and profit distributions, which are not subject to the 15.3% self-employment tax.
What is a reasonable salary? It depends on the type of business and the geographic area of the country. There is an entire body of law and IRS rulings on reasonable salary. Generally, it should be comparable to other people with a similar job under similar circumstances. Some accountants have suggested that for service industries the start-up pay should be allocated into thirds, with one third each going to owner salary, 1/3 going to owner distributions, and 1/3 going to operational costs (or, if not needed, to be distributed later).
Once you determine a reasonable salary, you can figure out how much you save with an s-corp election. For example, let’s say the company has $120,000 per year to pay the owner and all self-employment taxes and that the reasonable salary of the owner is $50,000. The owner would pay a total of $7,650 in self-employment tax. The owner walks away with $62,350 in distributions that are not subject to additional tax. If no s-corp election were filed, the owner would pay a total of around $15,000.
S-corp elections are your friend! Do the math first to confirm the savings. However, savings are generated most of the time when small companies file s-corp elections.