Have you ever heard of an S Corp? We have already discussed why you should incorporate your business and all of the financial benefits that come along with it at length. Today, we’re taking a closer look at one very specific type of business. A Subchapter ‘S’ Corporation, or S Corp, and why an S corp may be the right business structure for you.
You may have been working on a side hustle that has really taken off. Or, perhaps you’ve been brainstorming new business ideas and are ready to make things official. No matter your situation, we created this guide to answer all of your S corp questions.
Choosing the right business structure
There are lots of different types of business structures out there to choose from. Choosing the right structure almost always depends on what type of company you want to open. Consider whether or not you want to have employees, your budget, and where you see your business going in the future.
For those with a small sole proprietor side hustle, many times the smartest choice initially is a Limited Liability Company or LLC. This type of structure can assist you in legally separating yourself, and your assets, from your business. This means you can gain protection over any personal liability in case your business goes under.
That said, electing to file an LLC or a Corporation as an S corp involves minimal effort and cost in most states and virtually all scenarios. An S corporation is formed under a state corporation statute. It allows owners to funnel, or “pass-through” corporate income, losses, deductions, and credits to shareholders for federal tax purposes. As the owner, you automatically become a shareholder. That means that you report your business’ income and losses on your personal tax return and the tax is assessed at your individual income tax rates. The company itself, unlike a ‘C’ Corporation, is not treated as a taxable entity in and of itself, at least in the eyes of the IRS. Some states add a small tax to S Corps specifically.
LLCs and the FICA tax
Again, many solopreneurs ultimately choose to create an LLC. You’re legally separated from your business and your personal assets will remain just that: personal.
But, if you’re the sole proprietor of your LLC, you can get hit with undesirable, and arguably unecessary taxes. Owners of a single-member or multi-member LLC are also considered employees. That means you must pay a self-employment tax on your earnings. This tax is called the FICA tax. It includes 12.4% for Social Security and 2.9% for Medicare, resulting in a tax rate of 15.3%.
All this to say, you can avoid incurring at least a portion of self-employment taxes on your income when you file as an S corp. Like an LLC, it also protects owners’ personal assets from liability. But, the way you declare your income is slightly different. When you have an S corp, your earnings are de-facto reported as distributions. This is the key to avoiding what we at SoloSherpa most often call the “FICA” taxes discussed directly above.
As a note and reminder, whether you begin as an LLC or a C corp (a regular Corporation) you can still elect S Corp taxation with the IRS. There can be slight, almost immaterial advantages to forming an LLC or C corp initially, depending on the state, but you won’t be materially penalized in most cases for filing as either. If you need some help with this, please contact us for a consultation!
S corp status and payroll — reasonable compensation
You may also be wondering about S corp status and payroll based on what you have heard or read. The IRS does generally expect S Corp owners to run payroll in order to pay their employees and shareholders. This payroll will trigger the same FICA taxes noted above. However, you now have various choices and the ability to re-route a meaningful amount of profits to minimize FICA taxes.
Further, you can also choose to pay shareholders through distributions. We will have a future article all about determining reasonable compensation and further maximizing S Corp status. But, as an LLC you are “stuck” with the 15.3% additional FICA tax you must pay.
S corps enjoy more flexibility with payroll, especially if it’s a single-member corporation. You have the freedom to pay yourself when you want instead of weekly or bi-weekly. You can even choose to pay yourself very little throughout the year and then receive a large end-of-year bonus via distributions.
As you can see, there are several advantages to owning an S Corp, especially in terms of how you receive your distributions and how much you have to pay in taxes on them.
Time is of the essence
One of the biggest differences between an LLC and an S corp is that you need to apply to become an S corp by a certain date (March 15 in 2023). If you meet the IRS requirements, you can get S corp status by filing a specific form. Failing to do so could lead to you having to pay all of those unneeded taxes we mentioned above. However, once again you have options. While it is not easy, we have assisted clients in filing “late S Corp elections” up to 3 tax years into the past!
If you need help choosing the right business entity or are interested in applying to become an S corp now or for the past year, contact us for a consultation today!