Question of the Week
Should I make an S-Corp Election?
Happy Friday all!
The first tax deadline for S-Corporations and Partnerships is next week, and I’m fielding a lot of questions around the S-Corporation election. 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 gives you the ability to save on self-employment tax. Unfortunately, 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. Today, I want to talk a little about different small business structures, how they affect your taxes and what you should consider in choosing the structure that’s right for you.
Small business organizational structures
The simplest form of business organization for very small companies is sole proprietorship, where 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 personal savings, college accounts for your kids, even your car. If you want to shelter personal assets from legal liabilities, you have a choice between 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, and 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 that you have invested in the business. However, you should make sure to keep your personal and business assets separate to prevent someone from “piercing the corporate veil.” Simply put, that means a creditor can sue for your personal assets because your business and personal assets are commingled and your LLC only serves as a shell for a separation that doesn’t actually exist.
You also have to take a few more steps to set up a LLC than you do for a sole proprietorship. You have to file articles or organization with your state, and you should have some sort of operation agreement that explains how the business will carry out its mission.
One last potential pitfall of the LLC is that you have to pay self-employment tax on all business profits because, for tax purpose, you and the business are one in the same. The self-employment tax rate is 15.3%, which consists of 12.4% in for social security and 2.9% for Medicare. You may remember these amounts that were withheld from your pay stubs when you were an employee.
A partnership is a business shared by multiple owners. A partnership is similar to a sole proprietor in that the business 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 business.
- Limited Partnership: Here, there is at least one general partner who is 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 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 type of business structure as much as it’s an elected tax status. That status, however, comes with operational costs.
To create an S corporation, you have to file articles of incorporation with the state, appoint officers and create bylaws for the business. 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-S 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 on and costs for S-Corps. But you can obtain significant tax savings if your business ends up making a substantial profit.
Quote of the Week
“Major organizational changes create uncertainty. But the point is to move quickly – faster than you are comfortable – because in hindsight, you will always wish you had made changes even sooner.” – Irene Rosenfeld
Task of the Week
If you are one of those people contemplating changing your business structure, below are some questions to answer. Let me know if you have any additional questions!
- What type of business do you have? Service businesses effect both the reasonable salary requirement and the ability to take the QBI deduction.
- What are your business goals? Do you want simplicity and like less structure? Maybe an LLC or partnership is for you. Would you rather pay everyone involved a steady salary and take distributions? Think about having an S-Corp.
- How much of the income is derived from your work? Check out the IRS ten-factor reasonable salary test.
- Are you able to follow corporate formalities? You can hire someone to help with this.
- How much of your net business income is above or below the social security wage base ($142,800 for 2021)? The more above the wage base, the more appealing the 20% QBI deduction.
- Which retirement vehicles are you using? A single-member LLC allows you to save faster with a Solo 401k. If you have multiple people and/or employees, you will have to consider other retirement vehicles like a 401k or SIMPLE IRA.