You've started a new business. You have an LLC, an EIN number and you've opened your business bank account. After some time has passed, you begin collecting payments from customers and paying expenses. Now what? Let's start by discussing the tax savings available through the S-Corporation.
You might remember from my last post that a single member LLC, is treated as a sole proprietorship for tax purposes by default. The business net profit is reported on the individual 1040 income tax return. The net income of the business is usually subject to 2 types of tax. Income tax AND self-employment tax. What is self-employment tax? If you've ever been an employee, you've probably seen FICA withholding on your paystub right? FICA is social security and medicare withholding. When you are an employee, you pay 7.65% out of your paycheck and your employer matches this at 7.65% out of their own pocket. 15.3% gets paid in but you only had to pay half of it. As a business owner, you actually pay the full 15.3% and it's collected from you on your 1040 Individual income tax return. This can take new business owners by surprise. If the business owner is in the 22% income tax bracket plus they have to pay 15.3% for FICA, that's a whopping 37.3% before taking into account any state or local income tax. As a brand new business, this can make getting started pretty tough. The silver lining, is that FICA taxes are only paid on earnings. Not on things like investment income or passive income.
In struts the S-Corporation to save the day. An S-Corporation Owner that actively works in the business, may be treated as both an investor (i.e. a shareholder) and an employee. The income the S-Corporation owner makes can be divided into 2 buckets and self employment tax will be paid on only a portion of the net income related to the owner's earnings as an employee. The amount of income related to the owner's investment as a shareholder, is free of self-employment tax.
There is a an important rule in place, called the reasonable compensation requirement for an S-Corporation owner. This requirement is that the owner should pay themselves as an employee, on payroll, a reasonable compensation for work performed. The requirement only exists if the owner takes distributions. The owner could elect to take no distributions from the business in that year. In that case, there is no requirement to pay a reasonable compensation. However in the following year, or whenever the owner does begin taking distributions, they will have to classify enough as compensation to cover any prior years when distributions were not taken.
Here's an example of the tax savings available through the S-Corporation. XYZ LLC has net income for the previous year of $125,000. If XYZ LLC did not yet file an S-election and was taxed as a sole proprietorship, it would owe 15.3% or $19,125 in FICA. Ouch. Remember that's in addition to income tax. Let's say that XYZ LLC had done the S-election and is being taxed as an S-Corporation. The owner determines that a reasonable compensation for work performed by the owner was $50,000. The other $75,000 flows through free of self-employment tax, as investment income to the owner as a shareholder. That means a savings of $11,475 or 15.3% of the $75,000. That's a LOT of tax savings.
It is in the business owner's best interest to keep their employee compensation as low as possible, since they will be paying the FICA taxes on it. So how do we determine a "Reasonable Compensation?' At Tax Planning Pros, we walk you through a detailed questionnaire and analysis, to help you comply with and figure out a reasonable compensation, so that you don't overpay. We help you keep your taxes as low as possible and ensure you take full advantage of the tax savings available through an S-Corporation. Let us help you set up your S-Corporation correctly, handle payroll and save you a lot of money. Click here to get started.