S Corps Explained: The Good and the Bad of Electing to File as an S CorpFeb 02, 2023
I love S Corps and I think it’s a great strategy, however I have seen businesses file too early. The deadline to elect to be an S Corp is March 15th, so now is a great time to think about it. That being said, once you do file it’s nearly impossible to undo, so make sure you’re sure before electing. Keep reading to learn about what it is, how it changes things for your business, and an example of how it can save you money (and, of course, the importance of bookkeeping).
What is an S Corp?
An S Corp is solely a tax filing status with the IRS. For example, when starting out I was an LLC, and later on I told the IRS I wanted to be taxed as an S Corp. So now I file a separate tax return for my business and personal taxes. It creates two separate tax returns. When you’re an LLC, you file ONE tax return and everything goes on your personal tax return. Once you elect to file as an S Corp, you’re saying you want to be taxed as a corporation, separate from your personal taxes. When you do that, it changes the way money flows.
If you are an LLC or sole proprietor, the way that you pay yourself is through owner’s draws. You transfer money from your business account to your personal account. It is not an expense to the business, it’s simply a transfer from your business account to your personal. It doesn’t go on your profit and loss, it’s not a tax deduction, it’s just a transfer. When you switch to an S Corp, you’re required to pay yourself through payroll as a W2 employee with a reasonable compensation (your CPA can help you come up with what that reasonable compensation amount is). With all of this information, be sure to talk with your tax preparer and bookkeeper to see if it’s the right decision for your business.
The Benefits of Filing as an S Corp
When you pay yourself as an S Corp, like I said you’re a W2 employee of your own company. So now your compensation (via payroll) goes on your profit and loss, and can be a deduction for your business. The benefit of this is that you do not have to pay self employment tax, which is 15.3% of your PROFIT for the year. That’s a lot of money, but there’s a catch. So don’t go running to file just yet!
As an example, let’s say you’re an LLC and you have $200,000 in sales, $60,000 of expenses, which makes your profit $140,000. Your self employment tax on that is $21,420. When you switch to an S Corp, that goes away and that gets replaced with what’s called payroll tax. It’s still 15.3%, but it gets split between you as an employee and you as a business owner. To try to put it simply without being confusing, you’ll be paid as an employee through payroll. To continue our example let’s say your reasonable salary is $50,000, that would put your payroll tax at $7,650. Compared to your self employment tax on the same amount of $21,420, that’s amazing savings.
So again, to recap with our example. Instead of filing as an LLC you file as an S Corp. You make $200,000 of sales, your expenses are $60,000, you pay yourself a salary of $50,000, then your profit is $90,000. So now you only pay that 15.3% of payroll tax on your $50,000 reasonable comp salary. So instead of paying it on a profit of $140,000, you’re paying it on $50,000 (your salary).
The Cost of Filing as an S Corp
The key thing to remember is that if you switch too soon, it’s going to cost you more. Now as an S Corp, you file quarterly taxes, unemployment tax, workers comp, a second tax return at the end of the year, etc. There are costs associated to switching to an S Corp so I want you to be very cautious when you switch. So again, talk to your tax preparer, bookkeeper, and/or CPA to see what options you have.
Another thing is that with S Corps, the salary is a MUST. You have to run payroll, and if not that’s a red flag to the IRS. In general, if your business is PROFITING around $75,000 in a year, it’s probably a good time to start thinking and talking with your CPA, bookkeeper, etc. about whether it’s a good time to elect to be an S Corp. March 15th is the deadline to elect for 2023, so start having that conversation now. And if not, keep it in mind for next year.
The Importance of Bookkeeping
Things change, and as you have payroll come through that affects so many different accounts on your profit and loss and balance sheet. It can get messy very quickly. I’ve seen so many times where payroll is not documented properly. I used to be a payroll specialist accountant and I know what to look for.
We really want to make sure you have your numbers up to date to know when the right time even is to elect as an S Corp. How are you going to know when to file? How are you going to know when you want to hire a virtual assistant, or bring on a second shooter if you’re a photographer? Growing your team, purchasing a studio, electing to be an S Corp, those are all BIG decisions. You want to make sure you know your numbers so you feel empowered and informed to make those decisions. For bookkeeping support, check out our Marketplace to do your books yourself or see if our monthly services would be a good fit for you.
Feel free to find me on Instagram or email me with any questions you have about S Corps!