Accountants see this all the time: a company making about $40K in profit decides to convert to an LLC because they saw someone advise it, either through a finance magazine, or on YouTube. They were told that S-Corp would save them money, but after a year, they found themselves paying more in payroll taxes than they saved on their taxes. What gives?
The company jumped the gun. There are advantages to being an S-Corp, but those advantages only apply under certain circumstances.
What Is An S-Corp?
According to Investopedia an S-Corp is a type of business tax status that allows a company to pass off some of its taxable income, losses, and deductions directly to its shareholders. This status is only available to companies with 100 or fewer shareholders and there are certain restrictions you must follow to maintain the status.
Why Switch to an S-Corp?
The primary benefit of an S-Corp is the profit splitting. As a business with any other tax status, every dollar you make is taxed as self-employment. As an S-Corp, however, you pay yourself a salary as an employee of the company and it’s only that amount that you’re taxed on.
This sounds great, but it comes with a number of restrictions on who is allowed to be a shareholder for your business, how many you can have, and you must pay yourself over a certain amount to maintain the status.
If you don’t meet these requirements, the IRS can reclassify your salary as wages and charge you back-taxes. If you pay yourself too much, the taxes on your payroll will end up costing more than you save. There is also a fee to incorporate.
So, your company needs to be making enough to afford the distribution first.
The Magic Number
How much do you need to be making at your company before it’s profitable to become an S-Corp? That’s actually a fairly simple answer: about $80K profit per year. If you’re below that level, the payroll taxes and cost of filing will eat up the savings, but beyond that point, the self-employment tax is usually well beyond the fee and payroll taxes.
Keep in mind that the tax benefits only stretch up to a point. Generally, once your company makes about $147K per year in profit, you’ll see the actual benefits reach a plateau. It’s still usually better to maintain S-Corp status than not, but you won’t see your returns scale much beyond that point.
Reasonable Salary
One of the requirements of the S-Corp is that you pay yourself a reasonable salary. Because you only get taxed on the salary, it’s tempting to give yourself a small salary to save money, but the IRS can reclassify your tax status if you don’t pay yourself what they call a “reasonable salary” for your business size. It should be in-line with the industry standards, which is something you and your accountants will want to keep track of as you plan your financial strategies.
Managing an S-Corp Can Be Tough Without the Right Help
In addition to the federal regulations, the sliding scale of “reasonable salary,” and all the restrictions that come with it, there are also state level regulations that you might be required to meet. It can be hard to manage an S-Corp. Getting the details wrong can result in a costly IRS audit, which nobody ever wants to deal with. If you aren’t the sort of person who’s good at fine details like that, then the best advice is to get help from a professional accountant. If you’re big enough to convert to an S-Corp, you can definitely afford one.
You should also consult with one before you convert, just so you know all the details and can make a good call as to whether or not it’s time to convert and how to manage the S-Corp.
Author Bio
Terri Stapley is the founder of Stapley Accounting, an Enrolled Agent, and a certified tax planner serving small business owners remotely from Utah. Stapley Accounting focuses on planning-first tax work, bookkeeping, and small-business advisory.
