With the next wave of COVID-19 upon us, what better way to spend our couch time than by researching the taxation structure of our business.  How thrilling!  Think about it, while drinking your Brew Dr. Kombucha (Clear Mind is my go-to), you could be nailing down the ins and outs of self employment tax and the qualified business income deduction.  Have I convinced you on the excitement of all this yet?  Let’s do this.

S Corporations (A.K.A. S Corps) sound fancy, dare I say…’S’exy?  There can be major benefits to electing the S Corp status.  The word choice is important here.  When I say ‘elect,’ I mean the action you have to take in order to become an S Corp.  The S Corp election is made by filing the correct form(s) with the IRS.  It is primarily available to LLCs and corporations.  Therefore, your business entity is already established, meaning the S Corp election doesn’t change the entity itself, just the taxation of it.  Still with me?


Let’s take a step back and review the business structures you are likely set up as or looking to become:

Business Structures

Sole Proprietorship

• Ownership: One person
• Liability: Unlimited personal liability
• Taxes: Pass through personal tax returns
• Pros: Easiest to form
• Cons: Business assets and liabilities are not considered separate from personal assets and liabilities
• Best for: individuals with a low-risk business or side hustle
  

Partnerships (Limited Partnership; LP - or- Limited Liability Partnership; LLP)

• Ownership: Two or more people
• Liability: LP (notice just one ‘L’) has one general partner with unlimited liability, all other partners have limited liability; a LLP (notice the two ‘Ls) has limited liability for all partners; check your state’s rules for specific protections.
• Taxes: Self employment taxes except for limited partners
• Pros: may provide better protection and can be used for businesses with multiple owners; may have reduced filings with the state; in an LLP partners are not personally liable for other partners decisions within the business (ex: malpractice suit)
• Cons: general partners are personally liable for business assets and liabilities whereas limited partners are not; not available for sole owner businesses; may face greater restrictions in some states
• Best for: businesses with multiple owners who want to establish more protection, but not formalize their business
  

Limited Liability Company (LLC)

• Ownership: One or more people
• Liability: Not personally liable
• Taxes: Pass-through personal tax returns, self employment tax, or corporate taxation
• Pros: flexibility with taxation, structured as separate business entity provides greater personal liability protection, less paperwork than corporation
• Cons: more paperwork and filings required as compared to sole proprietorships 
• Best for: Business owners looking to formalize their business entity and creating separation from personal and business liabilities; those who wish to elect an S Corp or C corp status

Now that we understand the business types, let’s address the question at hand. 


Why would I consider making the S Corp election?  

One main reason with two different subpoints: taxation.

1. S Corps avoid the double taxation faced by C Corps.
2. Shareholders and executives pay taxes on the dividends they receive from a corporation.  These dividends represent a share of the corporation's earnings.  However, corporations also pay tax on earnings which makes it a double taxation.
3. As an S Corp, taxes are only imposed on personal tax returns of the owners.  There are no taxes imposed on the S Corp itself.
   
4. S Corps allow owners to reduce their self-employment tax.
5. Self employment tax consists of two parts: 12.4% for Social Security and 2.9% for Medicare.  In 2020, the first $137,700 of earnings is subject to the Social Security portion.  Once your income hits that, you no longer pay the 12.4% tax for Social Security.  There is an additional 0.9% Medicare tax if your net earnings exceed $200,000 as a single filer or $250,000 if you’re married. 
6. S Corps are able to administer an employee wage from the business.  That wage is subject to self employment taxes.
7. Profit outside of the wage can then be paid to the owner as a distribution.  This distribution is not subject to self employment taxes, possibly saving 15.3% in taxes.  It will be still be subject to your ordinary income tax.
8. Without the S Corp election, a business may potentially have most of their profits subject to self employment tax.
   
   

Reasonable Wage

Saving 15.3% in taxes can quickly add up to thousands of dollars.  Therefore, the next best step would be to pay yourself little to no wage, and only pay yourself in owner distributions, right??  Yes, if that were permitted, which it’s not.  The IRS requires you to pay yourself a ‘reasonable wage.’  What’s a reasonable wage for someone in your profession?  That is what you have to figure out.  Some folks utilize websites like ZipRecruiter®  to get an idea of a reasonable wage for their position.  We’ve also seen people pay themselves a flat rate such as 30% of profits.  Whatever you chose, be sure you can defend it when and if you ever get audited.  

Qualified Business Income Deduction

One thing to look out for when it comes to making the switch is the qualified business income deduction.  It is a deduction provided to owners of a pass-through entity (which is likely your business unless you are a C Corporation). 

Plain and simple: the qualified business income deduction is up to 20% of your qualified business income. Ok… so what’s qualified business income (QBI)???  Your QBI are your profits (essentially).  You can get a rough estimate by taking the net amount of your income, gain, deduction, and loss from your business. In order for you to take the full QBI deduction, your taxable income limit (before the deduction is in place) is $326,600 and $163,300 for married filing jointly and single filers respectively.  If your income exceeds this threshold, your QBI deduction will be reduced.  The ‘reasonable wage’ you decided on is one factor that contributes to this reduction in QBI.  However, if your income is below the limits listed above, your QBI will likely not be reduced.

Let’s Wrap This Up

Why bring all this QBI...JKLMNOP stuff up?  Electing to be taxed as an S Corp can impact the amount of your qualified business income and therefore impact your qualified business income deduction.  Now there’s a sentence NOT bring up at a cocktail party… If your taxable income as a married couple is over $326,600, you will want to assess how filing as an S Corp impacts your QBI deduction.  Long story short, it gets complicated and it’s worth running the numbers.  

Additional Items to Consider When Electing S Corp Status

1. If you pay yourself a wage (a requirement as an S Corp as noted above), you have the added cost of payroll.  You will want to weigh the financial benefits of self employment tax savings vs. payroll expenses.
2. An S Corp may reduce the amount you can contribute to your SEP IRA.  There are ways to work around this.  We can help with that!
3. In order to elect the S Corp status, most will need to complete their paperwork by March 15th in the year they want to be taxed as an S Corp.  
4. If you ever decide to terminate your S Corp, you won't be able to elect for S Corp status again for five years, unless you get approval from the IRS.

What does Fyooz Financial Planning do? We are an LLC that has not elected the S Corp status. We are in the beginning stages of running the figures to see if it makes sense for us. You know who also is in this conversation with us? Our accountant.  Just like yours should be.  As a business owner, it’s vital to have your team of experts supporting you. If you’re not sure where to start when it comes to your business entity and elections, send us a note.

- Natalie

Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.