Reflection of the Week

 

Should I make an S-Corp Election? Part-Two!

Happy Friday, all!

Last week, we discussed making the S-Election for your business. I outlined the different business structures, and this week, we dig deeper into how you choose. So, let’s jump in!

 

Yes, you can save it taxes. Is it worth it?

Most of the talk around choosing an S-Corp vs. an LLC or Partnerships revolves around self-employment tax savings. For example, if you were an accountant who made $200,000 in net business income and gave yourself a “reasonable salary” of $100,000, you’d save $15,300 in tax by having an S-Corp vs. an LLC. That’s a nice chunk of change.

Partnerships operate similarly, as partners have to pay self-employment tax on all distributions and guaranteed payments. So, the savings rates still apply; they’re just split between partners.

The critical issue here is what constitutes a reasonable salary. This issue has long been contested, as people push reasonable limits to save in self-employment tax. Business owners have even more incentive now that the QBI deduction only allows a 20% deduction for profits from the business, not salary.

The IRS determines reasonable-ness on a case-by-case basis but offers ten factors as guidelines. These include your role and duties in the company, background and experience, and amounts paid to others in similar-situated businesses. It’s a grey area, but experts have developed some rules of thumb — for example, the ideal salary is equal to one-third of business income up to the Social Security wage base, or, more recently, the “perfect salary” is 28.57% of your income.

While I love a good rule of thumb, small business owners making decisions between these entities need to take extra precautions. If your business revenue comes primarily from your services, the IRS will likely see your business income as your salary. In other words, all of you solo accountants, advisors, etc., need to consider that it may not be reasonable for you to have any dividend income. That fact defeats the purpose of having a more costly and burdensome S-Corp.

Partners, especially those with multiple employees or contractors, have more flexibility since more people generate revenue for the business. The sticking point is that while shareholders can have different salaries in an S-Corp, distributions must be made based on ownership percentage. That means if shareholders each own 50% of the business, they must split profits 50/50. So, the administrative burden around salaries, bonuses, and distributions may offset some of the tax savings.

 

How to choose

These regulations are somewhat murky, and by now, you may be wondering if there’s any way to arrive at the right decision about business structure. I hope to equip you with enough knowledge and tools to converse with your tax or financial advisor effectively. In that discussion, take into consideration the following questions:

• What type of business do you have? Service businesses affect the reasonable salary requirement and the ability to take the QBI deduction.
• How much of the income is derived from your work? Check out the IRS ten-factor reasonable salary test.
• How many people are involved, and do you need flexibility in paying them?
• Can you follow corporate formalities and administrative tasks with the different structures? (You can hire help for this, but does that take from your savings?)
• How much of your net business income is above or below the social security wage base ($168,600 for 2024)? 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.

Also, remember that you don’t have to choose right away. As a single-member LLC, you can elect to be taxed as an S-Corp as long as the election is made no more than two months and 15 days after the beginning of the tax year you want the election to go into effect. You make the election on form 2553. You can also withdrawal that election by writing a letter to the IRS regarding your intentions.

One final word of caution: do not make these decisions in a vacuum. The savings in self-employment tax and QBI deduction must be balanced against one another. Additionally, a change in entity type can have long-lasting implications. We don’t know if the QBI deduction will be around after 2025. So, talk to your tax and financial advisor about how these provisions affect you.

 

Questions of the Week

• How much are you currently paying in Self-Employment tax?
• What would be the tax savings from eliminating some of that tax?
• Would it be an administrative burden to change your structure?

 

Reminder of the Week

The S-Corp and Partnership tax filing deadline is March 15th. And, yes, March begins next week!