We’re gonna let you in on a little secret.
Let’s say that, during the pandemic, you started up an online consulting service to make some income on the side. You probably weren’t expecting to start raking in six figures right off the bat, so it would have made sense to set up your business as a sole proprietor. It’s simple, inexpensive, and easy to organize — as a sole prop, you essentially are your business.
But now, you’ve picked up a boatload of clients, and what might have started as a side hustle is turning into a full-time venture. Working as a sole proprietor made sense before, but now that your business is growing, you’re opening yourself up to more taxes (and legal liability if you haven’t formed an LLC).
But you don’t have to.
At Boxelder, we have a secret weapon against extra taxes and liability for growing businesses: S-Corporations.
An S-Corp is a type of tax classification structure that has major implications for how money flows through your business. For freelancers and entrepreneurs who are able to work for themselves full-time, switching to an S-Corp could save them thousands of dollars in taxes per year.
And that’s just one of the structure’s many benefits. In this guide, we’ll go over everything small business owners need to know about S-Corporations.
What is an S-Corp?
Before we address the benefits of S-Corps, let’s first take a look at what they actually are.
An S-Corporation, according to the IRS, is a corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. If you are a shareholder of an S-Corporation, you report the flow-through of income and losses on your personal tax return and will be assessed tax at your individual income tax rates. This allows S-Corporations to avoid double taxation on the corporate income.
To qualify for S-Corporation status, a business must:
- Be a domestic corporation
- Have only allowable shareholders
- Allowed: Individuals, certain trusts, and estates
- Not Allowed: Partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
S-Corps vs. C-Corps
The main type of corporation is known as a C-Corporation, and businesses that form a corporation will default to a C-Corp unless they file Form 2553. However, it’s important to understand that these are very different structures.
The main differences between S-Corps and C-Corps involve taxation and ownership. C-Corporations get taxed twice: the company pays corporate income tax and shareholders pay federal income taxes through dividends. As we discussed above, S-Corporations have pass-through taxation, avoiding this double layer of tax. Additionally, S-Corps are limited to 100 shareholders who must be U.S. citizens, while C-Corps have no limits on ownership.
Benefits of S-Corps for Small Businesses
Again, S-Corps do not pay corporate taxes. Business profits or losses are passed through to shareholders, who report it on their individual tax returns, avoiding double taxation. Therefore, as long as your personal tax rate does not exceed the corporate tax rate, this will yield significant savings every year.
Reduced Self-Employment Tax
If you work for yourself, you are subject to self-employment tax, a rate of 15.3 percent to cover Social Security and Medicare taxes.
However, when you operate as an S-Corp, you are actually both an owner and an employee of your business, and you pay yourself a salary. As long as you pay yourself a “reasonable” salary (in the eyes of the IRS) through payroll, you only need to pay self-employment taxes (which are now called payroll taxes) on your “employee” wages.
This means that any income above your salary isn’t subject to payroll taxes, just your regular income tax rate.
Personal Liability Protection
As a shareholder, you will have limited personal responsibility for your company’s debts and legal liabilities.
It’s important to note that many, but not all, states recognize the legal protections offered by S-Corps. Your decision as to whether or not to incorporate will likely depend on your home base — be sure to check your state’s individual laws pertaining to sales tax, and always remember that 941 trust fund liabilities will pierce the veil of a corporate entity.
How To Set Up An S-Corp
Electing S-Corporation status isn’t as complex as it may seem. To set up an S-Corp, you must:
- File articles of incorporation or organization with your state office, and pay any required fees. You can find more information about registering your business at the local, state, and federal level on the SBA website.
- File Form 2553 with the IRS, after it’s been signed by all shareholders. The deadline is typically March 15.
While S-Corp elections offer massive benefits for many businesses, they are not ideal for everyone. Factors such as your annual revenue, home state, and company size will affect what sort of advantages or disadvantages an S-Corp status could provide for your business.
Luckily, at Boxelder Bookkeeping, S-Corps are our specialty. Our team has helped countless small business clients make this decision and ultimately save thousands of dollars in taxes each year.
We can also help with yearly S-Corp management, keeping your books balanced month-to-month so you’re ready to go come tax season — we are your one-stop-shop for entity formation, accounting, business bookkeeping, and payroll management.
For a free consultation and estimate of your annual tax savings, reach out to our team today. We can’t wait to start working with you!