An S-Corp is a tax election available to LLCs (it’s also available to Corporations, but I’m not getting into any Corp stuff here). If someone says they are an “S-Corp”, what they really mean is they are an LLC that has elected to be taxed as an S-Corp. See, LLCs by default are taxed exactly the same as a Sole Proprietor–so when people tell you that there are tax benefits to becoming an LLC, that’s simply not true by default. The tax benefits are available when S-Corp status is elected. Now, let me back up because there is a very black and white rule that will let you know whether or not S-Corp status will actually provide you with any benefits.
Because of the rule that S-Corp owners must be on payroll–and paying payroll taxes–it does not make any sense for a business owner to elect S-Corp status before they are making at least $30,000 – $50,000 in PROFIT annually. So, that’s income – expenses for the entire year. Before that point, you really are in no position to be paying yourself a “reasonable” salary. Now, what’s “reasonable”?, well that’s pretty subjective, but for most people, a “reasonable” salary is nothing under $30K per year at minimum. That’s my own professional opinion of a solid threshold. A lot of people are super eager to jump into S-Corp status at the get go because they’ve heard so many rumors about it–it’s more “legit”, there are insane tax benefits. These rumors are not true. It’s not more legit than a Sole Proprietor. And there definitely aren’t any tax benefits until you can actually meet the requirement to pay yourself and pay payroll taxes. In fact, becoming an S-Corp is a lot more work. That being said, when you do reach this threshold, it is definitely worth exploring.
The first step is to hire a CPA–someone like me! (Side note, if you want to explore working together, click here). I would never in a million years recommend S-Corp status to anyone who is not ready to outsource their bookkeeping to a CPA on a monthly basis. More on that later. Basically, when you’re ready to explore S-Corp status, you need to book a consultation with a CPA–backing up a second here, if you don’t have your finances organized, do that first (for more on how to get your finances organized in a really easy and quick way, download this free blueprint). Once you decide that S-Corp status will end up providing you with tax benefits, form 2553 needs to be filed with the IRS. The next step would be onboarding with monthly outsourced accounting and within that service, getting setup on payroll. If you’re not at the point where you can afford monthly outsourced accounting to the tone of $1K per month, it’s probably too soon for you to become an S-Corp. See, the whole point of being an S-Corp is because you have too much profit. More on that later.
As I had mentioned a few times already, the one very clear rule is that the business owner of an S-Corp needs to be on payroll–as in they are now an employee and the owner of their company–and they need to be receiving a “reasonable” salary. The reason you’ll need outsourced services is because as an S-Corp, your finances need to be maintained accurately and using a software. If you’re doing your own bookkeeping, I highly advise against softwares (read more on that here), but as an S-Corp it’s absolutely a requirement to have a CPA handling your finances. During tax time, you’ll have to provide a balance sheet–and that’s pretty hard to do with a spreadsheet. Not to mention, again, if you’re not ready to commit to the cost of monthly outsourced accounting, don’t become an S-Corp. When tax season rolls around, you’ll also need a CPA to file your taxes for you. This is because your taxes automatically become more complex. They are no longer filed together with your personal tax return, but rather on an entirely different tax return called an 1120S. Because of the complexities, the one thing that’s required for an S-Corp is hiring a CPA for monthly services and for tax prep.
As an S-Corp, you’re not taxed on your business profits. Instead, you’re taxed on your salary. The self employment tax rate is 15.3%. The amount of payroll taxes that you’ll pay total 15.3%. So this is where the minimum profit comes in. Ready for some math? Let’s go.
If you’ve got $30,000 profit as a Sole Proprietor (or an LLC without the S-Corp election), your business will pay about 15.3% of $30,000 ($30K x .153 = $4,590). Now, this is a ballpark estimate but it’s the quickest way to get a close ballpark estimate without spending 18 hours calculating things. Now, let’s say you’re an S-Corp with $30,000 profit–my professional minimum is a $30K salary, so let’s say you paid yourself a $30K salary–now your profit is at $0, but you’ll pay a total of 15.3% (half paid by your business and half paid by you as the employee) of that $30K salary. So guess what, you pay the exact same amount.
Now let’s see what happens when profit is a little bit higher. Let’s say profit is $50,000 for the year. As a Sole Proprietor, you’ll pay about $7,650 in taxes. As an S-Corp, let’s say you pay yourself a salary of $30K. You’ll pay 15.3% of that ($4,590). As an S-Corp, your profit is going to be reduced by your salary (this is NOT the case for businesses without the S-Corp election), so the profit of the S-Corp is now $20K. ($50K – $30K salary). And guess what, that $20K is tax free. Woop Woop! (You’ll still pay regular income tax based on your personal tax bracket, but you save all that self employment tax). So in the $50K example, you can see that there is a tax benefit: the Sole Prop paid $7,650 and the S-Corp paid just $4,590.
Spend your money! My personal favorite way to lower your tax liability–especially in the beginning–is to invest! Outsource the things you don’t want to do–this lowers your profit and thus your tax liability, and it frees up your time. Once you get to a point where you’ve basically outsourced everything you wanted to, you’ve invested and up-leveled your systems, processes, equipment, softwares, etc., and you STILL have $30K+ in profits at the end of the year, S-Corp is going to be your best bet.