There is a misconception floating around out there that an S-Corp is a standalone entity. Not true. There are basically three broad types of entity formation- Partnership, Limited Liability Companies (LLCs), and Corporations (C-Corps). Each can elect to be treated as an S-Corp for taxation purposes only under subchapter S of the revenue code, but the underlying entity and subsequent corporate governance is either a Partnership, LLC or C-Corp.
So while we might talk about your ‘S-Corp’, or ‘S-Corp Taxes’, we are truly talking about your partnership, LLC or C-Corp being treated as an S-Corp for taxation.
Avoid Self-Employment Taxes
A common complaint from those who own their own business is self-employment tax. Can you avoid, reduce, eliminate or lower your self-employment taxes or SE taxes? Yes, to a large extent actually but it takes some effort and an S-Corp Election
If you own a business as a single member LLC (one owner or shareholder), your business income will be reported on your personal tax return under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. The same is true for a business that has not formed a corporation, such as a sole proprietor and partnerships. You could easily pay an average of 30% (15.3% in SE taxes + 15% in income taxes) on all your net business income in Federal Taxes.
If you own an LLC and have elected to be treated as a S-Corp (Subchapter S) for taxation, the business now files a corporate tax return on Form 1120S. Let’s look at some numbers. These are based on using a salary of 40% of net business income for incomes up to $500,000.
Don’t get too hung up on the drop in percentages. Focus on the overall hard dollar amount. Notice the sweet spot at $100,000 to $150,000 (yes, it dips at $300K due to Social Security limits). Also consider that if you run self-employed health insurance through the business (and you should), savings jumps up even more.
Money Trail for S-Corp Elections
So, when your partnership, LLC or corporation is an S-Corp, you are both an employee and a shareholder. As an employee, your income is subjugated to all the usual taxes that you would see on a paystub- Federal taxes, State taxes, Social Security taxes, Medicare taxes, unemployment, and disability. However, as a shareholder or investor, you are simply getting a return on your investment, much like a dividend.
A K-1 is a statement that each shareholder receives, and is similar to a W-2, since it reports the income that each shareholder is responsible for from a taxation perspective. There are two type of K-1s for the purpose of our discussions- one is generated from a Form 1065, and the other is generated from a Form 1120S. A Form 1065 is also called a partnership tax return, and typically your K-1 will be subjected to self-employment taxes.
However, a K-1 generated from a Form 1120S (LLC or C-Corp, either with the S-Corp election) is reported on the shareholder’s personal tax return on Schedule E. Schedule E is the form used for rental properties, royalties, and other investment income including business income for an S-Corp.
And when we say self-employment taxes, we are really talking about Social Security and Medicare taxes. From a sole proprietor perspective, they are self-employment taxes. From an employee perspective, they are Social security (FICA), and Medicare Taxes.
Let’s look at another visual in terms of how the money travels.
So an S-Corp doesn’t pay taxes per se since it is a pass-thru entity, and passes its tax obligation to the investors. There are some states that charge a franchise tax, such as California and Texas and other states have an S-Corporation tax that is egregious, such a Tennessee.
Late S Corp Election
Form 2553 (the S-Corp election) must be filed with the IRS. It is typically due within 75 days of forming your business entity, however there is relief for the late filing of Form 2553, and we can guide you through that.
Please contact us today to get started on electing S-Corp status.