Welcome to Small Biz Mama, Episode 7: All About S-Corporations.
I have to say that this is one of the most frequent questions that I get, whether it's in our email or online, this is the thing that people reach out to me about the most. And so I thought I would just do a podcast episode about it. That way, not only will you have the information, but then whenever somebody asks me, I can just send them here.
So if you have asked me this question, welcome to the podcast. If you're listening and you like the information, please make sure that you subscribe to the podcast and share it out with other people as well if they're looking for this information.
What is an S-Corporation?
So first, what is an S-Corporation? An S-Corporation is a tax structure for a business. This structure is a little bit different than some of the other ones, but just like a sole proprietorship or a partnership, an S-Corporation is a pass-through, which means that the income from this business ends up on your personal tax return.
Now, you do have to do an S-Corporation tax return to get the numbers that would go on your individual return. But essentially what happens is we do a tax return for the S-Corporation and then you get something called a K-1 and the information from the K-1 goes on your individual tax return. If you're familiar with partnerships, partnerships also have a K-1 as well.
So, instead of doing a Schedule C for a sole proprietorship, you would have an S-Corporation tax return. You'd get a K-1 and then the K-1 would have your business profit on it.
Why is everybody talking about S-Corporations and why is this the next level thing? Well, when you own an S-Corporation, oh, actually let me take it back a step. When you own a sole proprietorship or a partnership, all of your income, including what you pay yourself, is subject to self-employment tax. Self-employment taxes, social security, and Medicare tax, and those taxes are 15.3% of your profit, right? So that's a good chunk of tax. For a lot of my clients, especially my middle-class clients, they pay more in self-employment tax than they do in income tax.
The difference with an S-Corporation is with an S-Corporation, you're going to put yourself on payroll, you're actually going to pay yourself W-2 wages. And those W-2 wages would be subject to social security and Medicare tax, just like when you're a sole proprietorship, all of your income is subject to self-employment tax.
However, the difference is that any profits that are leftover, so anything you don't pay yourself on wages is not subject to self-employment tax. It's just subject to income tax. And so for some people, it saves them a tremendous amount of tax. But here's the catch. You have to pay yourself a reasonable salary for what you do in your business.
So, you can't say, well, you know, I'm just going to pay myself $5,000 in W-2 wages and let everything else flow through as profit. That's not going to work. That's going to get you audited. You have to pay yourself a reasonable salary for what you do.
And how do you know what that would be? Well, I would ask yourself, if you had to replace yourself in the business, what would you pay that person? Another way to do it is you could go to salary.com and you could look up what somebody in your field makes.
And then typically because you're the CEO of your company, we add somewhere between 10 and 20% to that number, as a management sort of fee. That's how we come up with it.
The nice thing with salary.com and you can also look up your geographic area to see what people in your area make, so if you have a localized business, you know, that might affect your wages, either higher or lower. But that's a really good place to start.
How do you become an S-Corporation?
So now if that sounds good to you, how do you become an S-Corporation? Well, you need to file Form 2553. And I tell people that they should really think about doing this at the beginning of the year, especially if you already have an entity set up. So if you have an LLC already set up, you can take your existing LLC, you can use the Form 2553 and you can convert that LLC to an S-Corporation. If you are a DBA or you're doing business as a name right under your own name, and you don't have an LLC set up, then you would need to set up an LLC.
Now, if you do this in the middle of the year, then you're going to have to file both businesses separately, right? So you've got your sole proprietorship for the beginning of the year and your S-corporation for the end of the year. So you're really going to want to make sure that you do this at the beginning of the year or if you're going to do it midyear, either do it as of July 1st or do it at the end of a quarter or at the beginning of a new quarter. Because if you're going to file two tax returns, let's make it a nice clear cutoff.
When should you consider becoming an S-Corporation?
For most people, you want to consider becoming an S-Corporation when your profit is more than the reasonable salary that you would pay yourself, because if your profit is less than what you think is a reasonable salary, then you're not going to have any tax savings, at least not from self-employment tax. Plus you're going to incur some additional costs.
In order to do this, you're going to need a payroll service. We use a service called Gusto and if you go to SmallBizMama.com and click on the show notes for this episode, we've actually got a link to Gusto and if you sign up through our link, we do get a little bit of money back from them to thank us for referring, and it helps support the show, but it doesn't cost you anything more to use our link.
The nice thing with Gusto is, if you're the only employee, it's going to cost you about $45 a month, as of the time that I'm recording this in 2020, and they cover everything. They handle the direct deposit, they take out all the taxes, they send the taxes to the government for you. They create all the W-2s, they file all the taxes for the payroll which is pretty awesome. So all you have to do is basically enter in how much you make. And if you're on salary, you enter that once and then they automatically pay you every month or every two weeks or whatever pay frequency you want to use. It's a pretty cool service.
You're also going to have to file an S-Corporation tax return, which, depending on your accountant could cost you anywhere between $500 and $2,000, typically. It could be more, could be less, but that's about the range. You may see that the cost of your individual tax return would go down a little bit. So, there are some additional costs involved with us, but, the tax savings are really, really nice. Plus, remember that any of these costs that you incur, whether it's the payroll service or your accountant doing a tax return, it's deductible for business purposes. So that'll save you a little bit of money too.
Once you have your S-Corporation setup, right, you're going to receive wages on a regular basis. One of the nice things with this is because you're having taxes taken out, that would decrease your estimated tax payments. So if you're going to do this, make sure that you notify your accountant, so your accountant can help you adjust your estimated tax payments.
The other reason that I use S-Corporations with clients is if they have trouble making estimated tax payments. And so, they're either getting behind on their taxes or they have trouble coming up with that large payment every year because they're not making their estimates. So even if they're not ready profit-wise we'll put them on payroll. Remember when you're on payroll, you're having social security taxes taken out, your company is matching those and you're also having your federal withholding taken out. You're prepaying all your taxes just like you did if you've ever had a job, you know that you have your taxes taken out. So it's a way for us to make sure the taxes are going in on a regular basis, and decreasing the amount that would be due in April when we file the tax return. So that's another good reason to consider an S-Corporation.
I want you to think about this as an option. If either your profit is getting up there, or you're having trouble keeping up with your estimates.
So if you have any questions about S-Corporations, feel free to leave a comment on SmallBizMama.com or on any of our social media channels.
I think that for a lot of people an S-Corporation is a great option, but you want to make sure that it is the right time for you and for your business.
Alright, mamas, take care and I will see you soon.
Thank you for listening to Small Biz Mama with Kristin Ingram.
If you’d like to learn how to create more margin in your life, please visit us at SmallBizMama.com.