In todays world, there are very few tax secrets available that will have any significant meaning to you or your business. In fact, when you see headlines like the one used in this article, you should usually run away as fast as you can because you are probably about to be scammed. But today I’m going to tell you about one of the best kept secrets among small businesses; The LLC. taxed as an S-Corporation.
As we have discussed before, choosing the right business entity is extremely important to the success of your business. Not only does the entity you choose impact your exposure to legal liability, it can also significantly impact how much you pay in taxes. While there are several entities to choose from, the LLC. taxed as an S-Corp has the ability to save you thousands of dollars in taxes while maintaining the simplicity of an LLC.
What it is
An LLC. taxed as an S-Corporation is a business entity model that keeps the legal characteristics of an LLC., but has the tax characteristics of an S-Corp. In other words, it gives you the best of both worlds.
In a traditional S-Corporation, there is a lot of minutia that is required from the owners, such as having board meetings and keeping minutes of the board. These rules typically scare off small business owners who don’t have the time or resources to comply with them. But with the advent of the LLC. taxed as an S-Corp, these businesses can now get all the tax benefits of an S-Corp while ignoring most of the burdensome rules.
How it saves you money
The entity of choice for the majority of small business owners is an LLC. It protects them legally and is painless to set up and maintain. The problem with an LLC. is that every cent of money it makes in profit is subject to self-employment tax, which is an additional tax of about 15 percent.
In an S-Corporation, the only portion of the profits that are subject to self-employment taxes is the salary you pay yourself. Because of this, the IRS requires that all S-Corporations pay their owners a “reasonable” salary. We will do a future article examining what constitutes reasonable, but as a very safe estimate, assume that you pay yourself 50 percent of your profit as a salary.
Let’s take a look at exactly how an S-Corp is going to save you money. Assume two people both have small businesses selling widgets and net exactly $100,000 in profit. Company A is an LLC. and Company B is an LLC. taxed as an S-Corp. In order to meet IRS regulations, Company B pays himself $50,000 from the profits in salary. Also assume both business owners are single with no dependents.
In 2012, Person A would have had a tax liability from their business of $30,636. Person B would have had a tax liability from their business of $25,396. So with all other factors being exactly the same, the change in business entity from an LLC. to an LLC. taxed as an S-Corp was worth $5,240.
Who should consider making the change
As a general rule of thumb, switching to an LLC. taxed as an S-Corp will save you between 10 and 15 percent of the difference between your total profits and the salary you pay yourself. Using the example above, the total profits were $100,000, the salary he paid himself was $50,000, so the difference between the two was $50,000. And the taxes saved of $5,240 is roughly 10 percent of that $50,000 difference.
All this is a fancy way of saying the more profit you make, the more you will save with an LLC. taxed as an S-Corp. Once you start to make between $30,000 and $40,000 or higher in profits, it’s time to strongly consider making the switch.
How to make the switch
Becoming an LLC. taxed as an S-Corp is surprisingly very simple. Assuming you are already and LLC., you would simply file form 2553 with the IRS requesting to be taxed as an S-Corporation.
After being approved by the IRS, you need to make sure you are having the proper payroll taxes withheld and paying any insurance you are required to pay and you are all set. The only other difference will come at tax time when you will file form 1120S instead of the 1065 or schedule C you filed as an LLC.
There can be some headaches associated with becoming an LLC. taxed as an S-Corporation, but as you can see in the example above, the tax savings are likely more than worth your time and effort.
We will explore this topic more in the future, including a video on how to file form 2553 and what constitutes a reasonable salary. In the meantime if you are interested in talking to a CPA about your personal situation, you can contact us here.