Many entrepreneurs and small business owners start out as limited liability companies (LLCs) because of the ease of formation and liability protection. With a single member, tax filing is easy – just fill out Schedule C on your tax return with your income and expenses. But as your business grows, electing S-corporation status can save you on taxes.
When you file as a sole proprietor on Schedule C, you pay income tax on the net income of your business, which is fair enough. But you also pay 15.5% self-employment tax, or SE tax, on that net income. SE tax is the equivalent of the payroll taxes paid by employers and employees when you get a paycheck.
But when you elect S-corporation status, only a part of your business income is subject to SE tax. Your cash distributions will go into two buckets: tax-free distributions and a salary paid by your S-corporation. Net income from the S-corporation is still taxed on your personal return, but your salary is the only piece of that net income that’s subject to SE tax, which means you’ll save on taxes.
Now, it’s tempting to set the salary low, say at $20,000 and distribute $150,000 in cash. IRS rules state that your salary must be reasonable, and the IRS may reclassify your distributions as salary if they think your salary is too low. You’ll owe SE tax plus penalties and interest.
Interestingly, when the IRS does reclassify distributions as wages, they frequently reclassify only enough to bring the resulting salary up to the Social Security threshold. Above this threshold, SE tax drops to just 2.9%. For 2018, this threshold is $128,700.
When does it make sense to change the tax status of your LLC to an S-corporation? That choice depends on your individual situation, so contact our office and we’ll help you decide if this is a good option for you!