Are you looking to save on taxes? TaxHub has the perfect calculator for you! This guide will walk you through the steps necessary to convert your business to an S corporation, and then show you how to calculate your tax savings. With this information, you’ll be able to save Thousands on your taxes each year.
What is the difference between an S Corp and a LLC?
A LLC is a separate legal entity formed at the state level.
LLC’s (Limited Liability Company) can elect with the IRS to be taxed as either: Sole Proprietor, S Corp, Partnership, or Corporation by filing form 8832 Entity classification election. Forming an LLC at the state level is a cumbersome process. Here are the necessary steps:
- The first requirement is to file the “Articles of Organization” with the appropriate state agency responsible for business formation and compliance. This document includes basic information about the LLC such as company name, address, and names of the owners.
- These Articles of Organization must be accompanied by a filing fee. Fees vary by state and are typically within the range of $50 to $500.
- There are hardly any ownership restrictions or requirements, offering you flexibility to run your business according to your preferences.
- Once your LLC is created, remember to keep it in good standing by paying an annual or biennial filing fee to the state.
- If you wish to operate in a state other than your home base, you must register your LLC in that respective state.
Contrary to other corporate structures, an LLC has fewer legislative requirements, making it the preferred choice for small businesses. Lastly, this entity separates your personal assets from the company’s, providing a level of security for your personal finances in most instances.
An S Corp is a tax status election that your LLC, Corporation, or Partnership makes with the IRS to be taxed as an S Corp
Any legal entity (LLC, Partnership, Corporation) can use form 8832 to choose its tax status with the Internal Revenue Service (IRS). S Corp is the most common election for small businesses as it is the most effective way to lower tax liability . This strategy will not reduce income tax but it can lessen Self-Employment (Fica/Medicare) Taxes compared to a Sole Proprietorship or Partnership.
The S Corp election process involves completing IRS Form 2553, which requests the IRS to consider the entity as an S Corp for taxation. This form must be filed within 75 days of filing the business formation documents with the appropriate state agency. If not met within the time limit, the S corporation tax status will have to wait until the next year or file a request for late election relief with the IRS. It’s worth noting that electing an S Corp tax status involves compliance with more rigid rules and regulations—a critical consideration when deciding on the tax structure of a legal business entity.
How does S Corp taxation work?
Self employment tax on sole proprietor versus S corp
It is important to note that there is little difference in Income tax paid between an S corp and a Sole proprietor. The major savings come when you factor in Self Employment tax. More specifically, a sole proprietor’s entire profit is subject to self-employment tax. This means that if you’re a sole proprietor and your business makes a profit of $160,000, the employment tax on this profit would amount to around $24,480. Unlike S corporations, sole proprietors aren’t issued W-2 wages; they bear full self-employment tax and no payroll tax.
On the other hand, S corporation profits are not taxed as self-employment income, markedly reducing tax liability. The only income that an S corporation pays payroll taxes on is the W-2 wage that it pays to its business owners. Using the same profit figure of $160,000, if an S corporation issues a W-2 wage of $100,000 to its owner, the employment tax on this wage drops to $15,300. This represents almost a $10,000 savings versus sole proprietor on self employment tax!
But wait there is a catch…. S corporations are required to pay the business owner a “reasonable wage”. This wage is subject to employment taxes and constitutes business deductibles, striking a balance between S corporations’ tax savings and IRS’s tax collection.
Furthermore, lowering the reasonable wage benefits S corporation owners. Issuing yourself a lower W-2 wage decreases your employment tax while not impacting the overall profit your S Corporation makes. Since the greater portion of the profit isn’t subject to self-employment tax, this strategy results in substantial tax savings. However, it’s crucial to maintain a balance to avoid IRS scrutiny; the wage must still be considered “reasonable” for your industry and role, and adequate distributions should be made to shareholders.
Therefore, while S corporations can provide significant tax advantages over sole proprietorships through reduced self-employment taxes, various factors influence this potential benefit. Always consider consulting a tax professional to identify the best fit for your specific situation.
Tax Calculation example of Sole proprietor versus S Corp with same net profit
Sure, assuming the following:
- Sole proprietor making $75,000
- S Corp owner making $75,000 with a total owner wage of $48,750
Here’s how we calculate total income tax and self-employment tax for both:
In this scenario, S corp owners have their lower owner wages subject to self-employment tax, resulting in significantly less overall tax payable.
How to save thousands with an S Corp:
Step 1: Estimate your net profit for the tax year
Net taxable income for an S corp is calculated by adjusting its gross income. This includes the total revenue plus $150,000 of business expenses, salary of $50,000, and payroll taxes paid by the corporation. The adjusted gross income (AGI) of $95,741 is then reduced by a standard deduction of $12,000 to give a taxable income of $83,741. The total tax is calculated, and then subtracted from the AGI to yield the after-tax income.
Step 2: Determine the “reasonable wage” your S Corp will pay you
The IRS determines a reasonable wage for an S corporation owner based on various factors. These include the employee’s duties, training, and experience, the time contributed to the business, dividends paid to shareholders, non-shareholders’ wages, and wages for comparable services in similar businesses. Owners need to avoid reducing their wages below reasonable amounts, as significant consequences like payroll tax and negligence penalties may be imposed. It’s important for owners to know what the reasonable salary range is according to IRS laws in their states and to pay themselves within that range. They can reference similar salaries on websites like Glassdoor or the US Bureau of Labor Statistics to help establish these amounts.
Step 3: Compare annual cost of maintaining an S Corp vrs tax savings from Scorp
Maintaining an S corp involves a variety of expenses, including:
- Minimal IRS filing fees.
- Additional bookkeeping costs.
- Payroll costs, especially if LLC already has employees.
- Mandatory owner salaries, which should be substantial and reasonable.
- Annual distributions that must reach at least $20,000 for the S corp to be financially beneficial.
- Penalty costs from IRS if an LLC owner forfeits a salary.
If these costs are not offset by tax benefits and yearly profits of minimum $40,000, maintaining an S corp might not make financial sense. However, when carefully managed, S corps can significantly reduce tax liabilities.
Step 4: Create an LLC in your state
To form an LLC, file the Articles of Organization and the required filing fee with the business formation and compliance agency of your state. Maintain good standing by paying the necessary annual or biennial filing fee. Utilize services like Incfile to prepare paperwork if you want the LLC to be treated as an S Corporations. Make sure to submit IRS Form 2553 within 75 days of the LLC formation to get tax election status. Alternatively, fill it by yourself, but IRS should receive this form within 75 days from the formation or wait until the next tax year.
Step 5: File S Corp election with IRS
Form 2553, used to elect S Corporation status for your LLC, can be prepared by Incfile during your LLC setup process or completed personally. To submit the form to the IRS, sign and either fax or mail it within 75 days from your date of incorporation. Failing to meet the deadline may delay your S Corp tax status until the next tax year.
Step 6: Set up Payroll & Register with state as employer
Setting up as a payroll provider involves several key steps:
- Choose your business structure. This can be an LLC, S Corp, or Sole Proprietorship, depending on your long-term business and personal finance goals.
- Contact the Secretary of State office to learn about the specific registration requirements in your state.
- Complete the necessary paperwork and include all required information. Prepare your documents carefully to ensure there are no errors or omissions.
- Submit your paperwork and any requested fees to the Secretary of State.
- Wait for your application to be processed and your registration confirmed.
- Once registered, keep track of all tax and reporting obligations to the IRS.
Note that even after successful registration, it is important to work with a certified public accountant or other tax professional to calculate a reasonable salary, file your taxes, and manage your payroll responsibilities. Remember, compliance with state and federal tax laws is essential.
Step 7: file annual 1120S and state S Corp tax return
Business owners have several options when it comes to preparing taxes, including a 2022 small business tax calculator that computes based on entity type, filing status, revenue, total expenses, among other factors. If additional support is needed, a Pro from the platform can manage your taxes for you. Alternatively, you can input your annual net income from self-employment into the calculator, and then import the results into TurboTax for assistance. Other available calculators include a Self-Employed Tax Deductions Calculator, Tax Bracket Calculator, and W-4 Withholding Calculator.