As a small business grows, the type of entity should be looked at. When a business is small, it may make sense to be a sole proprietor. But as the business grows, you may get some significant tax savings by changing the entity to an S corporation.
When does it make sense to consider such a change?
At the end of the day, if your net income (your income after deducting all of your expenses) ends up being somewhere around $85,000 to $100,000, that’s probably about the time that you should consider being an S corporation, because at that level, there can be some noticeable tax savings by paying a lower amount of the self-employment tax.
What do you mean by “a lower amount of the self-employment tax?”
As a sole proprietor, you pay a self-employment tax on the entire amount of your net income. Let’s say you had $100,000 in net income; the self-employment tax would have been $15,300 on that $100,000 worth of income.
Now, let’s say that you change and become an S corporation. As an S corporation, you only pay Social Security and Medicare tax on any W-2 wages that you received. So rather than paying taxes on the full $100,000, you’re paying Social Security and Medicare on, say, $75,000 worth of wages. That would be somewhere around $11,500 worth of tax, and the other $25,000 you would take out as what’s called S corporation distributions. But those S corporation distributions are not subject to the self-employment tax. So that savings could be somewhere around $3,800.
Then you have to consider, ‘If I have to pay self-employment tax on $100,000 worth of income as a sole proprietor, why don’t I become an S corporation and just have zero wages—then I have to pay zero Social Security and Medicare taxes?’ That’s one of the “tricks” that the IRS really looks into, and so they scrutinize S corporation wages paid to officers very closely.
Would changing to an S corporation also save on income tax?
The savings would be very marginal, so this really isn’t an income tax conversation. You’re going to have the same basic tax if you were a sole proprietor or an S corporation, but what you really save is on that self-employment tax.
Does an S corporation add complexity?
It really does. This is the point where I say you really have to have some tax savings in order to really benefit. When you think about it, as a sole proprietor, you don’t need payroll if it’s just you. But as an S corporation—even if you’re the only employee—you need to do payroll, which means you have to do quarterly reports, payroll reports, W-2s, all these things that you have to do when you have payroll added to your system … and that makes for more complication.
You also have to file a separate return. As a sole proprietor, you can just file that income and expenses just on your regular return—pretty easy to do. But as an S corporation, you have to file a whole other corporation return. So you have to file two returns, and of course there’s the excess cost in doing that.
I’m sure there are many more things to consider when making the change.
Absolutely. This is the time that you would want to consult with a tax professional.