When to Have Your LLC Taxed as an S-Corp

Is Now the Time to Have Your LLC Taxed as an S-Corp?

You may have heard friends or colleagues talking about converting their LLC to an S-Corp to save money on taxes. While making this change is relatively straight-forward, deciding on the right moment to do so and using your new status as an S-Corp to effectively decrease your tax liability takes planning. Are you considering making this change for your business? Below we’ll look at some of the factors to consider when exploring this change.

Prefer listening over reading? My guest spot on this episode of the Business Time podcast goes through a high-level overview of this and other related topics.

A quick refresher…

When starting a business, it’s common to set yourself up as an LLC to protect yourself and your assets from the business’s liabilities. If you are the sole owner of the business, the LLC will be a single-member LLC (“SMLLC”). By default, a single-member LLC is taxed as a disregarded entity, which means that, for tax purposes, it effectively doesn’t exist. While the default status for a SMLLC is a disregarded entity, electing to be taxed differently is a straight-forward process (referred to as making a Check the Box Election). SMLLC’s are eligible to be taxed in one of three ways:

  • Disregarded Entity – the SMLLC does not file a tax return. It reports its income and expenses on the sole owner’s personal tax return using Schedule C or Schedule E
  • C-Corporation – the SMLLC is its own entity, separate and distinct from its owner, and pays taxes on its profits at the corporate level. Dividends paid by the corporation to the owner are taxed on the owner’s personal tax return as well (you may have heard of this referred to as “double taxation”, referencing the tax paid by the corporation on its profits and the tax paid by the owner on the dividends)
  • S-Corporation – the SMLLC is its own entity, but instead of the corporation paying taxes on its profits, the profits (or losses) of the SMLLC are passed through to the owner (via Form K-1), and the owner is taxed on these profits on their personal tax return

Note – this election does not change the legal structure of the business, which remains an LLC, only the way in which it is taxed.

Another note – disregarded entities are not eligible to be taxed as partnerships, which is how multi-member LLCs are generally taxed. However, there are workarounds that can be implemented to have your business taxed as a partnership while still retaining 100% of the ownership if there is a need to do so.

There are many variables to consider when determining which entity type makes the most sense for your business (too many to discuss all of them here), but we’ll highlight a few of the big ones and will focus on the pros and cons of those that are most relevant to new small businesses.

Remaining a Disregarded Entity

Pros:

  • Low administrative costs, in part because no separate tax return needs to be filed in addition to a personal return and because payroll does not need to be set up for the owner to take a salary
  • Income is reported on the owner’s personal return, so there is no double-taxation
  • Potentially eligible for the QBI deduction
  • Losses can potentially be used to offset other sources of income in the current year
  • The owner can contribute up to 20% of their profit to a SEP (a type of IRA) or other retirement plan for a tax deduction, up to a maximum of $56,000/year (there are other options here as well that go beyond the scope of this article)
  • New York City’s tax rate on unincorporated businesses (like LLCs) is lower than its corporate tax rate and offers a large exemption, and some activities (such as real estate rentals) are exempt from this tax altogether

Cons:

  • Subject to self-employment taxes (“SE Tax”) equal to 15.3% on the profit of the business up to the social security maximum of $132,900 in 2019 and 2.9% on any profits in excess of the maximum
  • Cannot pay wages to the owner, which may cause the QBI deduction to be limited
  • Increased audit risk – If you are personally audited the IRS can review your business without having to open a separate case for the business since, as a disregarded entity, you and the business are effectively one and the same
  • Showing losses on a Schedule C can be a red flag to the IRS, potentially increasing the chances of an audit

Electing to be Taxed as a C-Corp

Pros:

  • Profits are not subject to self-employment taxes, however, if the owner wants to pull money out of the company it will either have to pay the owner wages (which are subject to payroll taxes) or dividends (which are subject to the individual income tax)
  • The corporate income tax rate was recently lowered to 21% with the passing of the Tax Cuts and Jobs Act of 2017
  • Dividends paid to the owner will likely be taxed at a favorable (lower) tax rate as compared to wages or other ordinary income
  • The details of the business are not reported on your personal tax return, creating separation in case of an audit

Cons:

  • Income is taxed twice, once at the corporate tax rate and once when paid out to the owner as dividends
  • Losses generated by the company cannot be used by the owner to offset other income (although they can be carried forward by the Corporation to offset future income)
  • Higher administrative costs due to the requirement to file a separate tax return for the entity

Electing to be Taxed as an S-Corp

Pros:

  • Profits are not subject to self-employment taxes. The owner is required by the IRS to take a “reasonable salary”, which is subject to payroll taxes, but the profit in excess of this salary is not subject to self-employment tax or payroll tax. What constitutes a reasonable salary depends on the facts and circumstances, such as the industry you operate in and the profitability of the business. For example, a service business will require a higher “reasonable salary” than a fixed-asset intensive business like a manufacturer
  • The owner can contribute to various tax-favored retirement accounts
  • The income passed through to the owner (via Form K-1) may be eligible for the QBI deduction, and the wages paid to the owner can be used to increase the limitation on this deduction (unlike an owner’s draw taken out of a disregarded entity)
  • Losses can potentially be used to offset other sources of income in the current year
  • Paying a bonus to the owner at the end of the of the year and having income tax withheld (instead of paying quarterly estimates) can be a powerful tax planning tool, as withholding taxes are deemed to have been paid evenly throughout the year even if they were withheld from a bonus on December 31st. This can allow you to withhold exactly the right amount of taxes with nearly 20/20 hindsight, therefore keeping that cash in your pocket (or invested in your business) all year and avoiding penalties for not paying estimates each quarter
  • The details of the business are not reported on your personal tax return, creating separation in case of an audit

Cons:

  • Highly inflexible business structure (e.g. distributions must be made pro-rate to all shareholders based on ownership percentage). This is less of an issue when there is only one shareholder, but there are still limitations that must be considered, especially in certain industries such as real estate or if you anticipate bringing in additional owners in the future
  • Paying wages to the owner decreases the income eligible for the QBI deduction, which may lead to a lower QBI deduction (depending on the level of the taxpayer’s total income)
  • Higher administrative costs due to the requirement to file a separate tax return for the entity and to set up and administer payroll for the owner
  • New York City does not recognize S-Corps and treats the entity as a C-Corp, imposing a corporate tax on the business

Okay, so what’s the strategy here?

For the purposes of this article, let’s focus on a SMLLC electing to be taxed as an S-Corp. At a high level, the goal is to elect to have your SMLLC taxed as an S-Corp when the tax savings from removing self-employment taxes from the picture (and increasing your QBI deduction) outweigh the additional administrative costs.

For example, if ABC Co., owned by Alex Smith (who has no other income or deductions) generates a $100k profit in 2019, things would play out very differently depending on its tax structure (for the purposes of keeping this example as simple as possible, we’ll set Alex’s personal tax rate at 20%):

As a Disregarded Entity:

  • ABC Co.’s $100k profit is reported on Alex’s personal tax return and is subject to SE Tax of 15.3% in addition to income taxes at Alex’s personal tax rate.
  • Alex’s tax would be calculated as follows:
Profit of ABC Co $100,000
50% of SE Tax (a deduction) (7,650)
Adjusted gross income 92,350
QBI deduction* (20,000)
Taxable income 72,350
Income tax @ 20% 14,470
SE tax (on $100k @ 15.3%) 15,300
Total tax $29,770

*I simplified this deduction for the purposes of this example. The actual calculation is more complicated and would yield a deduction that is less than $20k. For more information, check out this article

As an S-Corp:

  • ABC Co.’s $100k profit is reduced by Alex’s salary of $60,000 (which is subject to both payroll taxes of 15.3% and income taxes at Alex’s personal tax rate), bringing its profit down to $40,000.
  • Alex’s tax would be calculated as follows:
Wages $60,000
Profit of ABC Co 40,000
Adjusted gross income 100,000
QBI deduction* (8,000)
Taxable income 92,000
Income tax @ 20% 18,400
Payroll tax (on $60k @ 15.3%) 9,180
Total tax $27,580

 

The Outcome:

In this example, electing to be taxed as an S-Corp and taking a $60,000 salary lead to over $2,000 in tax savings for Alex. However, this is not a cut-and-dried situation, and an S-Corp will not always yield the best outcome. Several factors, such as the taxpayer’s (and their spouse’s) total income, the industry in which the business operates, and the profitability of the business need to be considered before making this change. Additionally, we must consider the additional administrative costs, such as filing a tax return for the business and setting up payroll for the owner (especially if there are not other employees for which payroll has already been set up). That said, we should also consider the non-monetary benefit of having the details of the business off of Alex’s personal tax return (which, in itself, is enough of an incentive for many business owners to make this election).

What are we looking for when we consider these additional factors? Among other things:

  • Does the taxpayer’s income level exceed the social security maximum? If so, the savings of removing the SE tax is only the Medicare portion, or 2.9%, instead of the full 15.3% in savings
  • Does the taxpayer’s income level exceed the QBI deduction’s phase-out thresholds? If so, we need to consider what industry the business operates in and the wages that the business pays to maximize this deduction
  • Does the taxpayer want to make tax-favored retirement contributions?
  • Does the taxpayer want to reinvest the business’s profits in the company to foster growth or pull out the profits to use for personal expenses?

In conclusion…

There are a lot of moving parts in play here, and there is no blanket answer as to which structure will work best for you. If your business is generating a profit and you are looking for ways to save on your tax bill, save for retirement, or minimize the exposure of having your business’s profit and loss details reported on your personal return, this is a strategy that should be considered carefully with your tax advisor. We can help you project out the effect of implementing a strategy like the one detailed above and determine the best course of action for you and your business.

As always, whether it’s us or someone else, you should always consult your tax advisor to review your specific situation before taking any action.