Will Filing as an S Corporation Reduce the Tax Bill of a Business Owner?
My business clients often ask me whether they would see a tax benefit if they converted their business to an S corporation. Unfortunately, there is no simple answer to the question because there are numerous pros and cons to operating as an S corporation. It all comes down to whether the advantages outweigh the drawbacks for a company and its owners.
While the owners of many sole proprietorships, partnerships, and limited liability companies (LLCs) would see a clear tax benefit from operating as an S corporation, some would see an increase in their tax paid if they decided to convert. There are also strict eligibility requirements for filing as an S corporation that cannot be met by all businesses.
One final issue that must be considered by Bay Area businesses considering S corporation status is that California imposes a 1.5% franchise tax on the net state income of S corporations and LLCs (with a minimum $800 payment, regardless of income). Limited partnerships and limited liability partnerships need only pay the $800 franchise tax. Traditional partnerships and sole proprietorships are not subject to the franchise tax.
What is an S-Corp?
S-corps derive their name from Subchapter S of Chapter 1 of the U.S. Internal Revenue Code. The subchapter provides that businesses electing to be taxed as S corporations will be treated as passthrough entities for tax purposes, just like LLCs, partnerships, and sole proprietorships.
S corporation status allows business owners to enjoy the liability protections offered by the more traditional C corporations, but without the double taxation. It is often said that C corporations are subject to “double taxation” because their income is taxed as income to the business on its corporate tax return and again as income to the stockholders when distributed as dividends.
To operate as an S corporation, a business must meet all four of the following criteria:
- Have 100 or fewer shareholders;
- Operate as a domestic business entity;
- All shareholders must be U.S. citizens or legal U.S. residents; and
- The corporation may only have a single class of stock.
The Tax Advantages of an S Corporation
- Passthrough taxation. Business income, as well as most tax deductions, credits, and losses, are passed through to the owner and not taxed at the corporate level.
- Salary and dividend payments. The owner of an S corporation can lower his or her tax bill by choosing to receive both a salary and dividends from the company. Dividend payments are not subject to the federal self-employment tax and the company may deduct the cost of wages paid when calculating the amount of income it is distributing to shareholders as dividends.
- Simplified transfer of ownership interests. Ownership interests in an S corporation can be transferred without triggering any adverse tax consequences.
Disadvantages of Filing as an S Corporation
- Corporate formalities must be followed. An S corporation is still a corporation that must observe all of the formalities required in California. Additionally, the IRS may terminate an S corporation’s status for failure to follow those formalities.
- Strict profit and loss allocation. Since S corporations are limited to one class of stock, they have no way of easily allocating income or losses to specific shareholders. Partnerships and LLCs may set out allocations in their operating agreements.
- Additional IRS Scrutiny. While S corporations enjoy some freedom when it comes to allocating distributions to ownership as salary or dividend payments, the IRS monitors those payments closely to ensure that the division is reasonable. Wages that have been recharacterized as dividends by the IRS will reduce the corporation’s deduction for compensation paid. Dividends that have been recharacterized as wages may increase the company’s employment tax liability.
- Fringe benefits are taxable. Many of the fringe benefits an S corporation provides to its stockholders that own more than 2% of the corporation are taxable as compensation.
- Calendar year. An S corporations is required to adopt a calendar year as its tax year unless it shows there is a business purpose for using a fiscal year.
TCJA Created a New Deduction
The Tax Cuts and Jobs Act (TCJA) of 2017 implemented a provision that allows individuals to deduct 20% of their qualified business income (QBI) from an S corporation or other passthrough entity. For 2020 the deduction begins phasing out for individual taxpayers earning $163,300 and is phased out entirely at $213,300. For married couples filing jointly, the QBI deduction begins phasing out at $326,600 and phases out entirely at $426,600.
QBI includes the net income, gain, loss, and deduction from a trade or business. However, QBI does not include investment-related income or losses, including capital gains or losses, interest income, or dividend income. Additionally, QBI does not include any amounts paid to an individual by an S corporation as reasonable compensation for his or her services. Thus, if the owner of shares in an S corporation receives wages of $50,000 and $50,000 in passthrough income, the shareowner will be allowed a 20% deduction on the $50,000 in passthrough income ( $10,000), but no deduction for the wages paid.
By the Numbers: Converting from an LLC to S Corporation
The table below shows how the owner of an LLC with $100,000 in net income for 2020 would benefit from converting to an S corporation. Please remember that the table is only provided as an example and that the tax benefits enjoyed by each business will vary based on their specific circumstances and some companies may face higher tax bills after conversion.
|Effective Income Tax Rate (estimate, state and fed)||30%|
|Self Employment Tax Rate||15.3%|
|Self Employment Tax||$15,300|
|Minimum Franchise Tax – California||$800|
|“Take Home” Cash||$53,900|
|Shareholder’s Reasonable Salary||$50,000|
|Employer Payroll Taxes||$3,825|
|S-Corp Tax Rate (California)||1.5%|
|California S-Corp Tax ($800 minimum)||$800.00|
|Employee Payroll Taxes||$3,825|
|Annual Payroll Processing Costs (estimate)||$750|
|Annual S-Corp Tax Filing Fees (estimate)||$1,000.00|
|Worker’s Comp (Ownership Exemption)||$0.00|
|Total Additional Costs||$1,750.00|
|“Take Home” Cash||$60,947.50|
As you can see, the owner of this particular LLC would save more than $7,000 annually in taxes and increase take home cash by 13% by converting to an S corporation. However, the above table also shows how converting from an LLC to an S corporation increases the complexity of the business’s tax and compliance obligations. If the company uses an outside accounting firm those expenses are likely to increase.
Another added cost that is not reflected in the above table are the payments for an attorney to ensure the bylaws and other corporate documents have been prepared correctly. Many S corporations also choose to retain some type of ongoing legal representation to ensure that all of the corporate formalities are being followed so the company does not lose its corporate status.
California S Corporation Conversion
California has a streamlined procedure that allows the owners of LLCs to convert their businesses into S corporations by adopting a conversion plan and filing articles of incorporation that contain a statement of conversion with the Secretary of State. Submitting this document will automatically convert the LLC into an S corporation and transfer all business assets and liabilities to the new S corporation. There is no need to formally dissolve the LLC because this happens automatically following the conversion.
LLCs converting to S corporations will also need to file an IRS form 2553, Election by a Small Business Corporation. The IRS will usually treat the statutory conversion as if the LLC members formally transferred all of the assets and liabilities of the company to the S corporation in exchange for stock and then liquidated the LLC. However, the specific tax consequences of a particular conversion may vary from company to company.
Is S Corporation Status Right for My Business?
As we have outlined above, choosing S corporation status requires that the business owners carefully consider the possible tax savings as well as a number of other factors. While the choice to operate as an S corporation is often portrayed as simply checking a different box on your business’s tax return, it will require that the business start operating as a corporation and begin following corporate formalities. It will also impact the manner in which owners receive payment from the business. The experienced accounting professionals at Code Accounting are ready to help you weigh these factors and answer any questions or concerns you may have about whether S corporation status is the correct choice for your company.Tags: corporate conversions, incorporation, s-corp, self-employment tax
Categorised in: Planning, Taxes
This post was written by Sean Allaband