One of my favorite things about having a business is that making small changes can lead to big jumps in profit.
In this article I’m going to share how you can save thousands of dollars every year by simply setting your business up to be taxed as an S corp.
That’s not an exaggeration. This is one of the easiest ways to put more money in your pocket every year.
This will only take a few hours to implement, and it will pay large dividends for years to come.
Sound too good to be true?
It’s not. In fact, by filing as an S corporation in late 2017, I was able to save over $10,000 in taxes in 2018. That’s an extra ten G’s that went straight to my bank account. The same will be true for 2019 as well.
Disclaimer: This article is for educational purposes only. I am not a financial professional of any kind and am not qualified to give financial advice. Seek professional council when making important business and financial decisions.
Why Most Self-Employed Business Owners Should File as an S corp
There are several advantages of filing as an S corp, but there is one main benefit that stands above the rest…
…It can save you boatloads of cash on your taxes. (As I’ve already mentioned)
Here’s how it works.
As a self-employed business owner, you probably already know that you have some extra tax responsibilities that you didn’t have as an employee, the biggest one being Self-Employment Tax (aka SE Tax).
At the time of writing this (Nov 2019), Self-Employment tax is currently set at 15.3% of Net Earnings. That’s 12.4% for Social Security, and 2.9% for Medicare.
Just to clarify, Net Earnings is what you get when you subtract your expenses from your Gross Revenue. You can think of it as your profit BEFORE paying yourself.
So let’s say that you are a self-employed handyman who formed your business as an LLC. You work by yourself and have no employees. This year your business generated $150,000 in revenue and you had $50,000 in expenses (tools, gas, insurance, materials, etc.). That means your Net Earnings were a clean $100,000, which means you would pay about $15,300 in Self-Employment Taxes.
Here’s a quick breakdown for an LLC:
Gross Revenue: $150,000
Net Earnings: $150,000-$50,000 = $100,000
Self Employment Tax: $100,000 x .153 = $15,300
$15,300 is a lot of money to pay in taxes, especially considering that you still have to pay Federal Income Tax on a good portion of what’s left over.
Now, let’s say this year you got smart (or just read this article), and decided to take a few hours to request that the IRS treats you as an S corp.
You’ll have to jump through a few hoops to get it setup, but it only takes you about six hours total since your bookkeeper or accountant can help you with the process.
One of those hoops you have to jump through is that you have to start paying yourself an appropriate salary. So let’s say you decide that an appropriate salary is about $40,000 per year based on how much you’d have to pay someone if you hired them to do your job.
Now, let’s say that next year you make exactly the same amount that you made this year, except this time you have elected to be taxed as an S corp (smart move).
Here’s a breakdown of how SE Tax works for an S corp:
Gross Revenue: $150,000
Salary: $40,000 (determined by you)
Profit After Paying Your Salary: $60,000
Self Employment Tax: $40,000 x .153 = $6,120
Now, you only had to pay $6,120 in self employment taxes! That’s $9,180 less than before you setup your business as an S corp.
That is not a typo. You could save over $9,000 per year in taxes by simply knowing what to do and then jumping through a few hoops to be considered an S corp.
This is because as an S corp, you only have to pay Self-Employment taxes on your salary. The rest is considered profit that you can pay yourself through shareholder distributions (a fancy name for paying yourself SE Tax-free).
Of course, you will need to pay Federal Income Tax on those shareholder distributions because an S corp is what is known as a pass-through entity. Basically, the S corp itself doesn’t pay Federal Income Taxes. Any profits get passed through to your personal income and you pay Federal Income Taxes on the income. However, you’ll still end up saving a significant amount of money in taxes when it’s all said and done.
Before we get too excited let’s talk about…
The Downside of Filing as an S Corp
Of course, things are never really that easy, and as I mentioned earlier, you will have to jump through a few hoops.
Here are a few ways having an S corp makes things slightly more complicated:
- You have to deal with Payroll – This is actually easier than it sounds especially once you get it setup. For my business, I just hired my bookkeeper to handle my payroll as well. I pay her $70 per month and she cuts me a paycheck twice a month and makes sure taxes get paid.
- More detailed accounting is required – As an S corp there are more strict rules for accounting. I’m not going to get into what they are here, but just know that your accounting is held to a higher standard by the IRS. Again, I had my bookkeeper help me make sure my accounting practices were up to par.
- It’s more expensive to file taxes – I pay a pro to file my taxes. After switching to an S Corp, the fee I paid went from $350 to $650 (a $300 jump).
- You have to pay Employment Taxes – There are two additional taxes you’ll have to pay: Federal Unemployment Tax and State Unemployment Tax (FUTA and SUTA). These taxes are relatively small if you are self-employed, but they are there.
This might seem overwhelming at first, but it’s all pretty simple as long as you have an accountant or a bookkeeper who knows what they are doing to help you out. I worked closely with my bookkeeper to get it all setup, and all I paid was $150 for the initial setup.
Yes it is work, but it’s well worth the effort as you’ll see below.
How much would you save if you elected S corp status?
At this point you’re probably wondering…”Is this really worth the effort?”
In most cases, the answer is yes, it is definitely worth it, especially as your profits grow.
But I don’t want you to take my word for it. Take a look at the table below to help you estimate how much you could expect to save by electing S corp status for your business.
Table 1: Estimated Tax Savings By Electing S corp Status*
Let’s examine the table above for a second.
On the left, you have your Net Earnings which I explained above. That is basically your profit before paying yourself.
Next you have the “Salary Paid to Self” column which should be self explanatory – it’s the salary that you decided was a reasonable salary to pay yourself. Now if you’ve been paying close attention so far, you’re probably thinking…“Hey, why don’t I just pay myself a ridiculously low salary (like say $10K per year) so I pay even less SE Tax?” Well, as you may have guessed, the government would frown upon that and you would risk owing lots of money later in back taxes. So you want to figure out a reasonable salary given your job description. In the table above, I just set the salary as 50% of the Net Earnings. That is not for any reason other than to create this example table.
Next in the table, you have the red columns, which are the additional taxes and expenses that you may have as a result of managing an S corp, with the furthest right red column being a total of all of these. Of course, these taxes and expenses may be lower or higher for you, but the table should give you a good estimation.
Then you have the green columns. The one on the left is how much you’ll save on Self-Employment taxes based on the other numbers in any given row. The very right column is the Net Savings, which is how much extra money you can expect to put directly in your pocket (before federal income taxes) as a result of electing S corp status.
As you can see on the table, as long as you are making $15,000 in profit above what you pay yourself as a salary, having an S corp will lead to a net positive. And, the higher your profits are after paying your salary, the more money you will save by electing S corp status.
So if you were to make $100,000 in Net Earnings and pay yourself a $50,000 per year salary, you could expect to put an additional $5,104 in your pocket every year by electing S corp status.
Setting Up an S Corp
Actually, you don’t “set up an S corp” because it’s not technically a business entity like a C corp or an LLC is. Instead, you simply elect that your LLC or C corp be taxed as an S corp. It’s basically just a way to be taxed.
So first, you need to form your business as either an LLC or as a C corp. So if you haven’t done that, that’s where you’ll want to start. For most handyman businesses or self employed people, an LLC is the best choice, but that should ultimately be determined by you and a knowledgable accountant. I’m not an accounting professional.
Then, you fill out a few forms for the IRS. Which forms you submit will depend on your situation. Here are the forms you’ll need if you have an LLC:
- From 2553
- Form 8832
Honestly, all of this can get pretty confusing which is why I strongly recommend getting help from your accountant or a knowledgable bookkeeper. I recommend finding somebody who you will pay to manage your payroll, and have them help you get setup since they will benefit financially from doing so.
Time is Of the Essence!
There is one more important thing to know. If you want to elect S corp status, then now is the time to do it (before the end of the year). That’s because there is a deadline at the end of the year. If you miss it, you’ll have to wait another whole year and continue overpaying in taxes.
Also, you can’t elect S corp status for the current year. It starts the year AFTER you submit your paperwork and get approved. So you unfortunately won’t be able to save on 2019 taxes, but if you set it up now you will be able to save on 2020 taxes and in future years.
And finally, if you are just starting your business and feel overwhelmed, this is something that you can put on the back-burner. Don’t allow this minutia to stop your progress. You have bigger fish to fry like simply getting started. Just start out forming an LLC and you can tackle this problem when you have the time.
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