There usually comes a time when a successful small business owner wishes to incorporate or form a Limited Liability Company (LLC) for business or legal reasons. Many business owners are unaware of a business structure that often results in significant tax benefits.
What if I told you that you can avoid the double taxation that is usually associated with incorporating your business? As a business owner, you could save enough on self-employment taxes to offset the additional costs associated with incorporating and have some money left over to invest in other parts of your business. By making a timely S corporation election with the IRS, more money goes back to you and your small business!
Qualifying to become an S Corporation
Only certain entities can elect to become an S corporation, and they must maintain that status throughout the entire tax year to qualify for tax benefits.
- The business entity must be either a U.S. formed LLC or regular C corporation
- Cannot have more than 100 shareholders
- Must only have one class of stock
- All shareholders must be U.S. resident individuals
- U.S. citizens or legal residents of the U.S.
- Certain trusts and estates may qualify - check with your tax advisor
Benefits of S Corporations
While there are obvious benefits to incorporating any type of business, S-Corps offer unique and worthwhile benefits that other structures do not. Here are 5 of the top benefits:
1. Self-employment tax savings
The main benefit of incorporating as an S Corporation over being self-employed is the tax savings on self-employment taxes (Social Security and Medicare). For each dollar of profit, it could mean as much as 14.13% in tax savings.
An S-Corp must pay a reasonable salary to any shareholder/employee. While a reasonable salary will reduce profits, any profits that remain after deducting a reasonable salary and other tax deductions is no longer subject to self-employment tax.
For example, a self-employed individual who makes $100,000 would pay $14,130 in self-employment taxes. If that same individual earns the $100,000 through their S-Corp and pays a reasonable salary of, say, $40,000, only those $40k in wages are subject to social security and Medicare taxes. Through the S-Corp, their social security and Medicare taxes would be 15.3% (7.65% employer and 7.65% employee portion) totalling $6,120; compared to the self-employed taxes, saving $8,010 in taxes.
After determining what your reasonable salary should be, you can start with regular payroll. Setting up Wave Payroll is a breeze because it helps you manage your team and your taxes more efficiently, leaving you prepared for tax season.
2. Health Insurance Tax Savings
Most S-Corps shareholders/employees should be able to save additional payroll tax by having their S-Corp pay for their family health insurance coverage. As long as it is included as part of their wages, and their spouse is not eligible for coverage under a subsidized health insurance plan, this is another great benefit of incorporating.
While the premiums included as wages are taxable personally and subject to income tax withholding, the amount paid is deductible (as wages expensed by the S-Corp), and the premiums are exempt from employment taxes (FUTA, Social Security or Medicare). This means that the premium is considered self-employed health insurance and therefore is deductible on a shareholder or employee’s personal income tax return as well which results in income tax savings.
Let’s use our previous example of $100,000 of income and $40,000 of reasonable compensation salary. If we assume that $10,000 was paid for health insurance premiums, the amount of salary subject to social security and Medicare is reduced by the premiums to $30,000. Since we don’t need to pay taxes on the health insurance premium, this amounts to payroll tax savings of $1,530 (15.3% of $10,000).
3. Employee Expense Deduction Under an Accountable Plan
Under current tax laws, employees can no longer deduct out of pocket business expenses on their personal returns. As a result, the only option for employees to not be out of pocket is to get reimbursed by the corporation.
For an S-Corporation with shareholder employees, out of pocket business expenses can be paid by the employee and reimbursed by the S-Corp. These can include home office rent, car mileage or transportation costs, cell phone and internet plans, and more.
To do this, the S-Corp must set up an Accountable Plan. An Accountable Plan requires expenses to be substantiated for business purposes, where excess payments should be returned within a reasonable time period. Remember that the personal use portion of these expenses (i.e. personal mileage, personal cell phone calls and personal use of internet) must not be reimbursed by the S-Corp, and submitting incorrect expenses could be a red flag with the IRS. When creating an Accountable Plan, it can be helpful to keep a shortlist of popular deductions and expenses for you and your team.
4. Retirement Planning
With a SEP IRA (Simplified Employee Pension Individual Retirement Arrangement), an S Corporation can provide retirement contributions up to 25% of an employee’s compensation, or $56,000 (whichever is less) in 2019. Contributions to an SEP IRA must be made on or before the employee’s tax return due date.
An S-Corp, owned by either a single individual or a married couple, and without any other employees, can set up a Solo 401(k) plan and defer up to $19,000 of income (per individual) from taxes in 2019. As an employee, the amount of contribution made to a Solo 401(k) will reduce the employer’s SEP IRA contribution limit.
Incorporating as an S-Corp lets you defer paying taxes, but you will still need to pay them eventually. Any income will be taxed when it is taken out of the contribution plan at your gradual tax rates (tax rates depend on the year of the withdrawal, and can sometimes vary). There are penalties for withdrawing before age 59.5 (usually 10%).
If you decide to contribute to a retirement plan, keep in mind that the time of year you contribute can affect tax filing. Make sure to contribute before your tax filing deadline to make the most of your contributions.
5. Advantages of S-Corp Over Other Business Types
Here is a brief comparison of the benefits to incorporating as an S-Corp over other forms of business:
Advantages over Sole Proprietorship
- Limited liability – personal asset protection
- Unlimited life (S-Corp exists after passing of owner)
- Easier to transfer ownership of the business
Advantages over LLC / Partnership
- LLC Members / Partners cannot be employees
- S-Corp profits are not subject to self-employment taxes
Advantages over C Corporation
- Flow-through taxation (avoids corporate income tax)
Moving forward with business incorporation and the election
If you have decided to structure your business as an S Corporation, and if you are currently operating as a sole proprietor, it is best to seek a professional to assist with the formation of your LLC or corporation. If your business has other partners, shareholders, or members you will need to get them to agree to your decision. After creating the LLC or corporation, make sure to file the S-Corp election with the IRS within 2 months and 15 days from the incorporation or formation date. If you have passed that date, you may still qualify for late election approval.
As you look at incorporation and an S-Corp election you should weigh the tax benefits and potential administrative costs of the different structures. We see a lot of business owners not knowing their options and the associated benefits. We want to make sure you are informed.
Wave Advisors can help with your incorporation journey. The Wave team can support your S-corp planning by helping you understand if incorporating makes the most sense for your business from a tax perspective. They can also walk you through processes and forms, like election Form 2553, to help you prepare the strongest possible application, and file easily with the IRS.
Once an S-corp election is approved by the IRS, business owners can start using Wave Payroll as an ongoing feature to properly manage their finances and truly reap all of the benefits that come along with being an S-corp.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.