To S Elect or Not to S Elect? That is the Question…
About once a week I have a conversation with a small business client, acquaintance or a high school friend about electing S Corporation status on their single member LLC (Schedule C). Someone, usually their Uncle Joe, Sister Jane or some other business owner, told them that they will save so much money in taxes with an S election.
“Is that TRUE?!” they always ask me. In true CPA fashion my answer is…
Well, that depends.
I know, I know, but it really does.
A few bits of IRS code talk and compliance stuff that affects this analysis and then we will look at two scenarios, one in which an S Corporation election doesn’t create cost savings and one in which it does.
Okay the IRS compliance things to consider:
- S Corporation shareholders who work in the business are required to take a reasonable W-2 salary. What is a reasonable salary for the work the shareholder does in the business and all the hats they wear as a business owner? (Hint: Not the $48k that guy in the office next door is taking in salary while he rakes in $500k in revenue all by himself with little in expenses.)
- S Corporations are separate entities from their owners. That means a whole separate set of bookkeeping (which as a single member LLC should already be in place), and tax filings for the entity.
- S Corporations are pass-through entities. This means that the net taxable income of the business is passed through to its shareholders via a Schedule K-1 and taxed at their personal tax rates.
Okay, I made that as brief and painless as possible. Let’s hop into the scenarios. To keep things simple, in both scenarios the taxpayer is single and uses the standard deduction and has no other taxable income or deductions.
Scenario #1:
The taxpayer, David, has a single member LLC business that provides website building services. Let’s say David nets about $100k a year in this venture. At S Corporation election David determines that a reasonable salary for his location, professional qualifications, and duties is $85k. Payroll creates additional tax expense of $7k along with payroll filing and tax professional costs of $3.5k. David’s effective tax rate is 25% for federal tax purposes. Let’s look at how this might shake out for him in taxes and additional costs:
| Single Member LLC on 1040 Sch. C: | S Corp W-2 & K-1 Income Passthrough: | ||
| Sch. C Web Building, LLC | $100,000 | W-2 Wages | $85,000 |
| ½ SE Tax | (7,650) | K-1 Web Building, LLC | 4,500 |
| Total AGI Income | 92,350 | Total AGI Income | 89,500 |
| Std. Ded & Exemption | (10,350) | Std. Ded & Exemption | (10,350) |
| Taxable Income | 82,000 | Taxable Income | 79,150 |
| Taxable Income @ 25% | 20,500 | Taxable Income @ 25% | 19,788 |
| SE Tax on Sch. C Income | 15,300 | EE/ER Portion SS/Med W-2 | 13,005 |
| FUTA & SUTA Taxes | 500 | ||
| Payroll & Prof. Costs | 3,500 | ||
| Total Tax/Cost Outlay | $35,800 | Total Tax/Cost Outlay | $36,793 |
In this scenario, the election to be taxed as an S corporation costs the taxpayer a bit more than his current single member LLC status with the bonus headache of separate filings and payroll compliance.
Scenario #2:
The taxpayer, Jennifer, has a single member LLC business that provides social media marketing. The business nets about $250k a year. The company sustains five employees in addition to the owner.
With a S Corporation election Jennifer determines that a salary of $100k is reasonable for her professional qualifications and time in the business. Additional costs include her tax expense of $8.5k and tax professional costs of $2k. The business already has payroll processing costs due to the current employees. Jennifer’s effective tax rate is 30% for federal tax purposes. Let’s look at how this might shake out for her in taxes and additional costs:
| Single Member LLC on 1040 Sch. C: | S Corp W-2 & K-1 Income Passthrough: | ||
| Sch. C SMM, LLC | $250,000 | W-2 Wages | $100,000 |
| ½ SE Tax | (10,972) | K-1 SMM, LLC | 139,500 |
| Total AGI Income | 239,028 | Total AGI Income | 239,500 |
| Std. Ded & Exemption | (10,350) | Std. Ded & Exemption | (10,350) |
| Taxable Income | 228,678 | Taxable Income | 229,150 |
| Taxable Income @ 30% | 68,603 | Taxable Income @ 30% | 68,745 |
| SE Tax on Sch. C Income | 21,944 | EE/ER Portion SS/Med W-2 | 15,300 |
| FUTA & SUTA Taxes | 500 | ||
| Payroll & Prof. Costs | 2,000 | ||
| Total Tax/Cost Outlay | $90,547 | Total Tax/Cost Outlay | $86,545 |
In this scenario, the election to be tax as an S Corporation saves the taxpayer about $4k in total tax and costs. This client may consider an S election a good move for her business.
These simple scenarios show that an S election may or may not save the taxpayer taxes and other costs depending on the facts and circumstances of each business and the individual. Tax and other cost savings are just one of the many reasons to elect S Corporation tax status. Any discussion around an entity change should, of course, be made with the proper tax and legal professional counsel after careful analysis.