There’s a common question to address working with entrepreneurs and small business owners: Should I be an LLC or make an S corp election for my business to reduce taxes? We’re going to walk through the framework of this decision with real-life examples, so you can understand if it’s worth pursuing.
First, it’s essential to understand what self-employment taxes are. You’re subject to self-employment taxes if you’re an independent contractor, freelancer, entrepreneur, or operate a small business organized as a sole proprietor or LLC. This tax is 15.3% in addition to regular income taxes. The good news is that if your business is beginning to generate a decent profit, there may be a way to reduce the self-employment tax by electing to be taxed as an S corp.
A subchapter “S” or S-corp election is simply a tax election. An existing LLC must be in place to make an S corp election. In other words, if you operate as a sole proprietor, you’ll need to create an LLC before electing S corp status. A common misunderstanding is that an LLC is a tax benefit. Unfortunately, an LLC has no tax advantage over a sole proprietor.
Potential tax savings! Most small business owners make an S corp election to reduce self-employment taxes (It can also help streamline the business and cash flows). Self-employment tax consists of social security and medicare tax.
As a business owner, entrepreneur or freelancer, you’re considered the employer and employee. Meaning you pay both parts of social security and medicare tax. This tax comes out to 12.4% for social security tax (up to 147,000 in 2022) and 2.9% for Medicare tax, for 15.3%. Alternately, an employee at a company pays half of this or 7.65%, and the employer pays the other half.
Before we dive into how an S corp can reduce self-employment tax, let’s look at how a sole proprietorship or LLC is taxed.
*Self-employment tax is imposed on 92.35% of self-employment profit.
As you can see, the total self-employment tax is $14,130 on $100,000 of net income. Remember, net income is after all expenses. You’ll still pay regular income taxes on profits.
Let’s compare the same profit numbers to an S corp election. First, the salary component and distributions are an S corp’s most significant operational difference. Electing an S corp requires setting up a reasonable salary through payroll.
So how does that reduce self-employment tax? The salary or W2 wage is subject to self-employment tax. However, anything over and above the salary can be distributed as dividends that are not subject to self-employment tax. Here’s how self-employment taxes might look for an S corp:
$60,000 is paid as a W2 wage, and the remaining profits are distributed as dividends. The only amount subject to self-employment (Payroll tax when electing S Corp) is the W2 salary. Remember, you’ll still owe income taxes in addition. Here the total self-employment tax (payroll tax) is $9,180.
Now that we understand self-employment taxes for a sole prop/LLC and S corp, we can use this framework to analyze if it makes sense to make an S corp election.
When analyzing an S corp election, factor in additional expenses and time. There will be extra costs such as tax filing, payroll expenses, and management. In many scenarios, these extra steps could add complexity but are worth the tax savings. In addition, you’ll want to factor in federal and state income tax, along with the qualified business income deduction if it applies to you. We will stick to self-employment tax only to keep things simple and serve as a starting point. If it makes sense from a self-employment tax standpoint, consult with a tax or financial professional to analyze the total tax impact within your financial plan.
Ben wants to know if it makes sense to elect S corp taxation or wait until he’s earning more. Of course, if Ben has other income or a spouse with income, this would need to be included in the comprehensive analysis, but we will assume this is the only income for this example.
The LLC Breakdown:
Ben’s business is currently taking an owner’s draw of $50,000/year. This profit is reported on Schedule C of his tax return and flows to Form 1040 as self-employment income. The $50,000 profit is subject to self-employment taxes of $7,065. ($50,000 x 92.35% x 15.3%).
Can Ben save tax by electing S corp? Maybe. The most significant factor is a reasonable salary for his business duties. He will want to work with a tax or financial professional to help determine the salary, but he assumes $40,000 is an excellent place to start.
The S Corp Analysis:
In this scenario, the self-employment tax savings is $945. Next, Ben will have to determine if the $945 tax saving is worth the additional tax filing, payroll costs and setup, and other associated expenses. The extra costs and hassle may not be worth the squeeze in this example. At this point, Ben may consider putting more emphasis on earnings and growing the business until there is enough revenue to justify switching to an S corp.
The LLC Breakdown:
After expenses, Anna takes an owner’s draw of $145,000. Again, this profit is reported on Schedule C and flows into Form 1040 as self-employment income. The $145,000 profit is subject to self-employment taxes of $20,488. ($145,000 x 92.35% x 15.3%).
Can Anna save tax by electing S corp? At this level of income, it’s a real possibility. Anna must determine a reasonable salary for her work, so she starts with just over 60% of the profit for the analysis.
The S Corp Analysis:
There are real tax savings if Anna can justify the $90,000 salary as reasonable compensation for her work. Even with the increased costs for tax filing and payroll, the $6,718 in tax savings may be worth it. She has enough knowledge to take this to a tax or financial professional who can assist prepare a comprehensive analysis and fine-tune the salary. A lower wage will increase the tax savings, and a higher wage will reduce the tax savings.
An S Corp can give a business owner liability protection of an LLC and streamline payroll while potentially reducing self-employment tax. However, just because a strategy has the potential to reduce tax doesn’t mean it should drive the final decision. Make business decisions based on the goals and resources of the business first, then optimize for taxes. This post gives you a better understanding of how to analyze the self-employment taxes of an LLC versus an S corp election. Before implementing any strategy or electing S corp taxation, work closely with a tax and financial professional. When thinking through decisions as a small business owner or entrepreneur, there are many variables to consider. If you want to talk about your business, let us know!