Reflection of the Week

Should I make an S-Corp Election?

Happy Friday, all! I hope you had a good week.

We’re in the thick of tax season. And one of the business questions I get most often is, “Should I become an S-Corp?” Many small business owners think or have been told that the S-Corp election is the way to reduce taxes for your business because it allows you to save on self-employment tax. While accurate, blanket advice like that doesn’t always make sense. Whether to elect this status for your business as an S-Corp. or not is a technical question with broad implications.

Because of the complexity associated with this decision, I split up this reflection into two different parts. Today, I’ll talk about organizational structures overall, and next week, I’ll dive into how to make the S-Election if it makes sense for your business.

Small business organizational structures

The most straightforward business organization for very small companies is sole proprietorship, were you and your company are essentially the same entity. That works up to a point. But what if your business gets sued? You could lose your house, your savings, your kids’ college accounts, and even your car. If you want to shelter personal assets from legal liabilities, you have a choice between a few other business structures.

Single Member LLC

To avoid the unlimited liability of a sole proprietorship, you can turn to a single-member LLC (Limited Liability Company). LLCs are straightforward to administer; in most cases, you’ll still report income on a Schedule C. But you gain some protection because your business is considered a separate entity.

In an LLC, you are only liable for damages up to the amount you invested in the business. However, you should separate your personal and business assets to prevent someone from “piercing the corporate veil.” Simply put, a creditor can sue for your personal assets because your business and personal assets are comingled, and your LLC only serves as a shell for a separation that doesn’t exist.

You also have to take a few more steps to set up an LLC than you do for a sole proprietorship. You have to file articles or organizations with your state, and you should have an operation agreement explaining how the business will carry out its mission.

One last potential pitfall of the LLC is that you have to pay a self-employment tax on all business profits because, for tax purposes, you and the business are the same. The self-employment tax rate is 15.3%, which consists of 12.4% for social security and 2.9% for Medicare. You may remember these amounts that were withheld from your paystubs when you were an employee.

Partnership

A partnership is a business shared by multiple owners. A partnership is similar to a sole proprietor in that the company isn’t separate from the owner for liability purposes.

Depending on the type of partnership, you may or may not have to register with the state. Partnerships fall into four categories:

• General Partnership: Ownership, profits, and liabilities are generally split evenly among partners, and partners have equal ability to bind the business to contracts and loans. All partners participate in the day-to-day operations of the company.
• Limited Partnership: Here, there is at least one general partner responsible for the business and its operation and one or more limited partners who invest financially but do not actively manage the business and don’t have liability for any more than they’ve invested in the business.
• Limited Liability Partnership (LLP): All partners actively manage the business but have limited liability for one another’s actions. LLPs are not permitted in all states and usually only pertain to certain professions, such as doctors, lawyers, and accountants.
• A limited liability limited partnership (LLLP):  Like an LLP, this type of partnership is only available in some states. It operates like an LP, with at least one general partner who manages the business, but the LLLP limits the general partner’s liability so all partners have liability protection

For tax purposes, the business files Form 1065, and each partner receives his/her/their share of the business profits and losses on a K-1. The payments are then taxed to the individual on their income tax return and subject to self-employment tax as with a sole proprietor and LLC. A partner may also receive guaranteed payments, not tied to their partnership share, for services in the business.

S-Corporation

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits to their shareholder for federal tax purposes. Thus, the corporation is not subject to tax itself. Instead, shareholders of S Corporations report the flow-through of income and losses on their personal tax returns and are assessed taxes at their individual income tax rates. An S-Corp isn’t a business structure as much as an elected tax status. That status, however, comes with operational costs.

You file form 2553 to make the election to create an S corporation. In addition, you have to adhere to corporate formalities, including meetings of the board of directors and taking meeting minutes (even if you’re the only one in the meeting!). You will have to file a Form 1120 for the business, and the business profit or loss will flow through to you personally on a Form K-1. Lastly, you can make the election to be taxed as an S-corp if you’re an LLC or Partnership. More on that below.

Many one- or two-person businesses find these requirements too time-consuming and expensive. Additionally, some states, like Illinois and New York, levy additional taxes and costs for S-Corps. However, you can obtain significant tax savings if your business makes a substantial profit.

 

Questions of the Week

• How is your business structured?
• When was the last time you revisited this structure?
• Is it time to change?

 

Reminder of the Week

The S-Corp and Partnership tax filing deadline is March 15th. So you have about a month to get your return in. Start prepping now!