When is a good time to be taxed as an S-Corp?
Do you remember when you started? I remember hanging my first shingle in early 2009… I set myself up as an S-corp and had my Jerry McGuire moment. I said, “I’m starting my own practice, who’s coming with me
“!? Just like in the movie it was just me. When I met with an accountant a year later she told me “well you kind of put the cart in front of the horse by organizing as an S-corp.” At that time I had no clue what she meant. With hindsight she was right.
My accountant initially said you put the “cart in front of the horse” because I wasn’t making enough money when I started… most people don’t. If you start out as a sole proprietor (or a single member LLC) then you’ll only have one set of tax returns… your personal taxes with the addition of schedule C & E (because you have self employment income). Until you make money, remaining a sole proprietor is probably a prudent play because you don’t have to pay to register a business name with the state, file articles of incorporation, pay someone to write corporate by-laws, apply for your EIN and various tax ID numbers with the state & city… it’s costly and enough admin work to consume a few days every year.
Turning the Corner, So You’re Showing A Profit!
Let’s say that you do start making money and you’re even showing a profit after a few years! You’re paying for office space, upgrading equipment, purchasing advertising, and doing things you wouldn’t have thought of a few years ago. Then you hear about S corporations and wonder, “why should you all the sudden start taxing yourself as an S-corporation?!” Well besides the mindset that you have 2 separate sets of books and that you transform into “You Incorporated“
, you could save quite a bit on self employment taxes. Simply put, if you’re business revenue is decent ($80,000 and up), you might want to look at being taxed as a S-corp.
An easy rule of thumb for most people is… if I hired someone to do what I do (with my current revenue), what would I pay them? If you would pay them less than the total amount you currently pay self employment taxes for… then it may be time to convert into a S-corp. If you become a S-corp (or an LLC taxed as an S-corp), you create a company which you own… then you hire yourself as an employee. In tax terms, you trade your Schedule C for a K-1. When your company, or any company, pays you $10,000 in wages, 7.65% is withheld from your pay check for the employee’s portion of payroll taxes. This is broken down into 6.2% Social Security and 1.45% Medicare. Your company must also pay 7.65% for a combined percentage of 15.3% for FICA taxes. Adding on 25% in income taxes equates to a 40% tax rate… yuck!
Therefore, a $10,000 salary costs you $1,530 in additional FICA taxes beyond income taxes. Said in a different way, if you pay yourself $50,000 when $40,000 could have been a reasonable salary, you just wasted $1,530. Even a $5,000 delta equates to $765. As such, your S Corp officer compensation needs to be reasonable
, sure, but it also needs to be as low as reasonableness and not-so-common sense will allow. IF you are in a service industry… (i.e. you trade your services/expertise as a consultant, real estate or insurance agent, consultant, investment advisor, health care specialist, software developer, etc…) this usually amounts to 40-50% of gross receipts.
For example, if your gross receipts are $100,000 and you are paying self employment taxes on more than $50,000 that year, it’s probably a very strong idea to consider being taxes as a S-corp. Even if your gross receipts are $60,000… are you paying self employment taxes on more than $30,000 a year? If yes, you still might want to consider it…but the math ends up pretty close to break-even at that point.
Jumping the Gun
My first year in business I paid myself $7000 that year, and paid my accountant $500 to do my taxes… and looking back on it now she was doing me a favor. Despite gross revenues of about $40,000… I could only pay myself $7000 after those fixed expenses (that one shouldn’t incur when starting a business as a twenty something with no business operational chops). Back then I thought, all businesses must have an office, separate work computer, a proper website owned by a .inc, and those fees and service costs got up there. That’s when my accountant said, “well ya kind of put the cart before the horse.” Yep.
The following year was a nice turn, I ended the year with $83,921 in gross receipts and paid myself $38,719 in W-2 wages. Pretty close to what I made back when I was working for Brown & Brown, my first professional job out of college. That year I reported $4,947 in profits! That’s $4,947 I didn’t pay self employment taxes on… or $756.89! Yay me! I saved money! Not so fast…
It took me another year before I think I grasped this because it seemed like such a small number… but there is something called unemployment tax… which you have to pay when you begin paying yourself wages (i.e. as an S-corp). For the first $7000 in wages you pay yourself… your company (that you didn’t have as a Sole Proprietor) pays a 6% tax for the federal unemployment tax or “FUTA”. That’s $420 in taxes that I just never even thought about… so my $756.89 self employment tax savings was really only $336.89. Nothing to write home about… (NOTE: Most very small employers pay state unemployment tax so the actual overall taxes paid for unemployment is lower than $420 per employee as FUTA drops to 0.6% with the other 5.4% awarded as a credit for paying state unemployment tax.)
What to Do?
If you’re in that $80-$100K in gross receipts then hopefully business keeps getting better so eventually your wages all but “cap out” and more of each additional dollar turns into profits. Then you’ll be reporting $20,000 in profits… or a $3,060 FICA savings per year! That $300-$420 in unemployment taxes doesn’t seem like such a drag anymore! If you’re in a service industry and gross more than $100K a year, I’d highly recommend looking into being taxed as an S-corp if you aren’t currently doing so.
Also don’t forget about new 199A pass through tax deductions! You’ll receive a 20% federal tax break on your “profits” (for most industries)! If you intend to maximize “profits”… an S-corp seems to be a good way to benefit from that strategy. There’s some other factors down the line that you’ll want to have awareness of… like in Philadelphia the business income & receipts tax along with the net profits tax vs. school income tax that’ll lower your marginal profits as you declare more profits.
But chances are if you are here and paying full price for health insurance on the individual marketplace, thinking about being taxed as an S-Corp should be on your radar because you’re making money! Well done, keep going & growing! Working with us is a way to test drive the S-corp vehicle as the wages you pay through Fellow Travelers is much like how it would be if you were an S-corp. Plus, if you’ll save money on health insurance, take that into consideration as well!