Time for an S Corp… or Not

Your accountant told you that you need an S Corporation… They often do, when your business tips over about $100,000.

“It’s great…” they told you. “You only have to pay out part of your profit as salary, so you don’t pay social security or Medicare on the rest.”

And you know S Corps have to be great, because a lot of your business associates have them. Yeah… right.

But did they ask any of these important questions?

• What are the alternatives?
• What is your income level likely to be in future?
• Do you have a lot of expense deductions?
• Do you really want to avoid payroll taxes? These determine your eligibility and the amount of your social security and Medicare benefits later in life.
• What are your retirement objectives?
• Are you a Specified Services Trade or Business?
• Do you qualify for the Qualified Business Income deduction?

Important Background

Qualified Business Income Deduction (QBI)

The QBI deduction is 20% of net business income. Business income does not include salary income or capital gains. QBI is limited by the SSTB rules described below.

Specified Services Trade or Busines (SSTB)

SSTBs include businesses such as Law, Performing Arts, Consulting and Health. If your income is greater than $164,900 ($329,800 if married) and you have a SSTB, you can’t claim the Qualified Business Income deduction. If your business is not an SSTB, you may claim all or part of the deduction if your business pays a salary or has substantial assets.

S Corp Benefits and Other Characteristics

• You can deduct all your business expenses.
• You can contribute to a retirement plan with very high contribution limits, such as a SEP IRA or a 401(k).
• You are an employee of the S Corp, so you must pay yourself a “reasonable” salary. The purpose is to ensure you pay social security, Medicare and other payroll taxes. A reasonable salary may be set low enough to minimize your payroll taxes.
• An S Corp doesn’t directly pay federal tax. Net income after deducting your salary and retirement contributions passes through to your personal tax return. Some states have a nominal tax on S Corps.
• Salaries and retirement contributions reduce your Qualified Business Income (QBI).
• Ironically, paying a salary may allow you to claim the QBI if your income is high, and your business is not a SSTB.
• S Corps offer limited liability protection if operated properly. There are other ways to protect yourself, so this issue is not discussed here.

Your Current Status

Employee

If you receive a W-2 as an employee, an S Corp may be right for you, depending on your business expenses and retirement objectives… and if local law and your employer allow it.

• An employee can’t deduct their business expenses on their federal tax return, but an S Corp can deduct everything. An example is the entertainment industry, where writers, directors and actors pay agents and lawyers a large percentage of their income. They often form loan out companies, because they would otherwise be classified as employees.
• An employee’s retirement contributions are limited to the rules for employer sponsored 401(k) plans, if offered, and traditional or ROTH IRAs.  S Corps permit plans with much higher contributions.
• Employee salary income isn’t eligible for the 20% Qualified Business Income deduction, but S Corp income is eligible.
• In favor of employees, the employee only pays half of their payroll taxes. The employer pays the rest. With an S Corp, you pay the employee and employer share.
• There is a strong movement to classify workers as employees. California introduced a law that makes it difficult to do otherwise, so your employer may not be willing to treat you as an S Corp instead of employee.

Sole Proprietor

This includes individuals who operate a business in their own name or a single member LLC, as well as independent contractors who perform services, but are not classified as employees.

Unless your income is very high, there may be no significant benefit to having an S Corp.

• You can deduct all your business expenses as a sole proprietor, just as you can with an S Corp.
• You can contribute to the same retirement plans with high contribution limits as you can with an S Corp.
• S Corp salary reduces QBI. As a sole proprietor, you do not pay yourself a salary, so it doesn’t reduce your QBI.
• Retirement contributions are limited by your business income, while an S Corp is limited to 25% of your salary. So with an S Corp, the higher your contribution, the higher your salary must be, further reducing your QBI. The actual retirement contribution reduces your QBI in both cases.
• You pay payroll taxes on all of your income, while with an S Corp, you only pay on your salary. If your salary is near or over the social security limit of $142,800, though, the difference is small.
• You are subject to the same Specified Services Trade or Business (SSTB) rules, with or without an S Corp.
• If you are not an SSTB, and your income is over the phaseout thresholds, paying a salary can allow you to take part of the deduction. This can only be done if you have an S Corp. But forget about it if you are a doctor, lawyer, consultant or movie producer.

Other Entities

I only recommend a single member LLC in special circumstances, but your situation would be the same as a sole proprietor. C Corps risk double taxation, and are probably not recommended for you. Partnerships are complicated by multiple owners, and should be reserved for a separate conversation.

Conclusion

If you are an employee with a lot of expenses that you can’t otherwise deduct – and your employer is willing – you may want to form an S Corp.

If you are a sole proprietor, you may not get much benefit, unless you are not a SSTB, and your income is so high that your S Corp salary allows you to claim the Qualified Business Income deduction.