S-Corp Conversions

Using an S-Corp to Lower Your Taxes

If you’re a small business owner, you’re well aware of the pain of self-employment taxes and how much they can take out of your pocket.  (And if you’re not yet aware, you’re in for a rude awakening next April.)  Converting an S-Corp is one popular way of reducing these taxes, leaving more money in your pocket.

What is an S-Corp?

An S-Corp is a special type of corporation that has fewer than 100 shareholders.  For tax purposes, its treated much like a partnership (even if you only have one owner).  The net income from the S-Corp is reported at the business-level and any profits flow through to any shareholders to be taxed on their personal returns.

Ok, but how does this help me?

If your business is currently a sole-proprietor or partnership, your compensation is simply the net income from the business at the end of the year – and this entire amount is considered your salary.  But if your business was an S-Corp you could pay yourself a set salary.  Why is that important?  Your salary is what determines how much you pay in self-employment taxes (Social Security and Medicare).  You will owe 15.3% of your salary in these taxes (subject to contribution limits).

The salary you set for yourself will be treated as another business expense, just as your rent or utilities expenses are reported now. The net profit at the end of the year then is treated entirely as a dividend. This amount still flows to you like it did before, only now it is entirely free of self-employment taxes.

An Example

Jim owns his own business as a sole proprietor.  He makes $200,000 in revenue and has $100,000 in expenses.  At the end of the year, the net profit of $100,000 flows onto his personal tax return.  He owes approximately $15,000 in self-employment taxes. He will also pay income tax on $100,000 of income.

Bob owns his business as an S-Corp.  He also makes $200,000 in revenue and he also has $100,000 in expenses.  Bob pays himself a salary of $60,000.  At the end of the year, he owes approximately $9,000 in self-employment taxes (15% of $60,000). The other $40,000 flows to him as a dividend.   Like Jim, he will pay income tax on $100,000 of income (the $60,000 of income on his W-2 and the $40,000 of income on the dividend).

Jim and Bob have the same revenue and the same expenses.  But Bob saves over $6,000 in taxes by converting to an S-Corp.  That’s money he can reinvest in his business or just go on a nice vacation with.

How do I set my salary?

For many business owners who decide to go the S-Corp route, this is the hardest part.  There are no black and white rules about what number to use.  The IRS requires you have a “reasonable” salary.  If you decide to give yourself a salary of $200 and keep the rest as a dividend, you’re likely facing an audit and/or a court appearance.

Some of the ways you come up with a “reasonable” number include what you would hire someone else for to do the same job.  You could also use your own past salary as a guide – for instance, many formerly salaried IT employees begin work as independent contractors doing the exact same work.  In that case it could reasonable to pay yourself what you used to make.

You could also hire any number of firms to provide a detailed report with recommendations on what you should set the number at.  This may give you peace of mind and lots of documentation to use if you’re ever challenged on it, but keep in mind the person responsible for your numbers being accurate will always be you.

What are the downsides?

Since nothing in life is free, there have to be downsides to this pathway to saving money on taxes.  The two largest are paperwork and fees.

As a salaried employee, you’re going to have to file quarterly payroll reports with the government.  You’re also going to have to file forms relating to unemployment insurance.  You’re going to file W-2 forms and a W-3 form.   While you’re welcome to fill out those forms by hand, realistically this means you’re going to have to use a payroll provider if you don’t already have one. These range in price depending on the provider, your number of payroll runs, and your number of employees, but generally cost between $30 and $50 per month. (If you don’t already have a payroll provider, I can do it for you.)

At the end of the year, you’re going to have to file a corporate tax return (1120-S) by March 15.  Corporate tax returns tend to be more complex (and expensive) than personal returns, and usually require the assistance of a tax professional.  In addition to the corporate return, you’ll obviously still have to file your personal tax return as well.

To decide if converting to an S-Corp makes sense for you, you’ll need to do a cost-benefit calculation.  If you can save $5,000 or $10,000 on taxes, paying someone to do the filings and spending a little more on tax preparation fees is a no-brainer.  But if you’re currently making $30,000 in profits and the conversion would only save you $500 in taxes (which would be eaten up by payroll and tax prep fees), it might not make sense for you at this time.

How do I get started?

If you’ve read all of the above and think converting to an S-Corp is the way to go, we should chat.

You’ll need to file Form 2553 by March 15 of the year you want the conversion to take effect.  (They have historically been lenient about ‘late’ filings if you decide to try to do it after that point, but it’s always easiest to follow the letter of the law.)

After filing that you can begin setting up the quarterly payroll filings.  You’ll also want to calculate your estimated tax amounts to ensure proper withholding.

I would obviously be happy to help with any of the steps above, or just talk through your various options. Drop me a line to set up a meeting.