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Understanding the Benefits and What to Consider Before Becoming an S-Corp

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Understanding the Benefits and What to Consider Before Becoming an S-Corp

When Should A Company Consider Becoming an S-Corp

When it comes to a business, finances are more than just reading a profit and loss statement, knowing what the balance sheet covers, and understanding the finances as a whole. There are also taxes, tax planning, and tax-saving strategies to help the business save money and be more profitable.

Money Saving Methods

One of the best ways to save that money is to make an S-Corporation election. An S-Corp election can save a business a ton of money by removing the owner from the tax equation and eliminating self-employment taxes. Self-employment taxes are a flat 15.3% in addition to typical income taxes for partnerships, single-member LLCs, or sole proprietorships. However, this isn’t the best financial decision or option for every business.

While electing to become an S-Corp can help avoid the self-employment tax, it is a requirement that any active owner—any owner who is active in running the business day-to-day—be paid a reasonable salary for what they do for the business. If a company has six shareholders and all six actively participate in the business, then all six must be paid a reasonable salary.

Unfortunately, there are no well-defined guidelines on what a reasonable salary is. While the IRS has a list of requirements, they don’t provide any salary guidance.

However, what has traditionally been an acceptable way to gauge a reasonable salary is for the owner to ask themselves, “What would I reasonably expect to get paid if I quit my business and went to work for a competitor doing the exact same thing?” Some of this will be based on the company’s size, what they are doing in the business, and how much time they’re involved.

If an owner is a part-time office manager and only does it part-time because other staff are running it full-time, their reasonable salary could be substantially lower than if they were full-time or a full-time field technician or full-time service manager. This is something for owners to keep in mind because if they’re drawing more than a reasonable salary for their position, their income will decrease when the election is taken, or they’ll need to invest more time into the business.

Payroll Problems

Another thing to keep in mind when debating taking an S-Corp election is that the owner salaries need to be run through payroll, meaning they’re going to have to pay income taxes, Social Security, and Medicare taxes, as well as the business paying Social Security, Medicare, and unemployment taxes.

Social Security and Medicare are split between the company and payroll to combine for the 15.3% that would typically be paid as the self-employment tax, which is what the self-employment tax is designed to cover: Social Security and Medicare. The savings come into play because instead of paying the 15.3% on all of the business earnings, it’s only being paid on the reasonable salary taken by the owners.

The first consideration of whether or not it makes sense for a business to be an S-Corporation is if the company is earning enough money to pay the owners a reasonable salary and the taxes that come with the salary. If it isn’t, the business cannot afford to be an S-Corp and won’t save anyone money. If the company is making enough money to pay a reasonable salary, other expenses need to be considered before making a final decision.

The second consideration is if the company makes enough to afford the additional payroll expenses in addition to the base salary. On top of being able to pay a salary, the company will also have to pay half of the Social Security and Medicare taxes, federal unemployment, state unemployment (depending on the state), and possibly other payroll taxes such as Washington’s Care Fund, or the company may be required to pay for Worker’s Comp.

Then there’s the cost of the payroll software itself and any additional expenses for things like benefits. A company typically spends 10-15% in addition to a base salary.

If a reasonable wage is $75,000 per year, 10% over that will be another $7,500, making the total cost of that one payroll $82,500 that the company will have to spend. If a business makes only $50,000 per year, it falls short by $32,000 of the minimum expected expense, not just $25,000. Even if it were making $75,000 a year, it would still have a shortfall of at least $7,500, causing losses for the business and owner.

When discussing tax-saving strategies, the red line, the bottom line, is not just how much is being paid in taxes or how much isn’t being paid in taxes; it’s how much it costs to save money in taxes in the first place that needs to be considered. So, based on the reasonable salary, typically speaking, a company will need to add $25,000 per owner or active shareholder before it makes sense financially to take that S-Corp election.

For an owner-operator working in the trades, if they’re in the field and not an office manager or something like that, then generally speaking, they will see that income-to-tax savings start to make sense at around $100-$120,000 per year in profit (not sales, actual profit).

Tax Savings for the Company

Another thing to consider when deciding to make an S-Corp election is the tax deduction associated with paying the self employment tax. While an owner will have to pay roughly $15,000 on $100,000 of income as a sole proprietor or single member LLC, 50% of that goes to reducing their income. Instead of making $100,000 for income taxes, that will be reduced by $7,500 so that they instead make $92,500.

This goes back to considering how much it costs to save money in taxes. For one person needing a reasonable salary, the company will be around $100,000-$120,000. For two owners, it’ll be around $150,000-$175,000 and will keep going up based on the number of owners in the company.

The final consideration for an S-Corp election is the additional cost of filing taxes each year. S-Corporations are required to file a separate business return rather than being able to file the business on the owners’ personal returns. This means more than double the cost of filing taxes since a business return usually costs more than an individual return. This also means more work for the owners to ensure they can get the required documentation and completed books to their CPA to ensure filing by March 15th.

While an S-Corp election can save a lot of money, there is no guarantee it will. For a more in-depth look at payroll taxes, you can check out this blog .If you want help deciding whether your business could benefit from becoming an S-Corporation, don’t hesitate to contact us!

Check out our YouTube video Should Your Business Become An S-Corp? Understanding The Tax Benefits And Costs with James for a first-hand recap. If you are still determining which plan works best for you, need additional help, or have any questions, Waterford Business Solutions is happy to help. Feel free to call us at 864-351-0852 or email us at Info@WaterfordBusiness.com.

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Understanding the Benefits and What to Consider Before Becoming an S-Corp