A common question we hear when filing the business taxes for our Colorado clients is: When should I switch to an S-Corp or is it more beneficial fiscally to stay as an LLC?
Before we dive directly into this question, let's start with self-employment taxes. What are self-employment taxes and whop are they affecting? Anyone who is a business owner who is also a 1099 contractor is subject to self-employment taxes. If you are one of these people, your wages do not have taxes 'built-in' meaning, these taxes such as federal taxes, state taxes, social security or Medicare, will be asked for at year's end. The government views you as both an employee and an employer! Social security taxes equate to over 6% while Medicare is close to 1.5%. Why is this important? Well if you're self employed you're paying this 7.5% tax on both sides as the employer and employee. A whopping 15% for simply being self-employed! If you look over your expenses and income, factoring out your net income - this is the amount that will be subject to this high 15% self-employment tax. An S-Corp allows one to not have to pay such a high tax because the government no longer considers you self-employed in the same way for tax purposes.
So let's dive deeper into becoming an S-Corp and how it can save us on taxes. To start off we need to answer the next question: What is payroll inside of an S Corporation? Well, the main idea behind this switch over is S-Corp owners becoming W2 employees underneath their own business. Thus they tax themselves as a W2 employee. The key difference between paying out through payroll and simply withdrawing money as a sole proprietor or LLC, is that the government considers you simply a shareholder being paid out through a distribution. Whether that be a check or a direct money pull from a bank account, the government does not consider these payouts as qualified for a deduction. The trade off here is that at year's end, as an S-Corp, the business owner has to pay payroll taxes while taking a Reasonable Compensation. What does this mean in laymen's terms? The government now considers you an employee not just a shareholder, thus eliminating the self-employment taxes.
Wait a minute! you say, does that mean I'm simply swapping out self-employment tax for payroll taxes?! yes, you are swapping one tax for another, so when does it make the most sense to switch to an S-Corp? As accountants, this question comes up quite a lot, and in Colorado, there is a certain threshold where it starts saving money by switching over. On average between franchise tax, tax preparation fees and payroll taxes, a business owner is looking at a yearly expense of $3000 to $3500. Geyer and Associates generally recommends you come see us to switch over when your business has a netted income of over $40,000 per year. This doesn't mean the switch is right for everyone, but for most businesses, the benefits start outweighing the costs at the $40,000 mark. That is when you should call us directly and ask about changing over.
One last thing, Why does the switch save so much money? Well it has to do with that term Reasonable Compensation we mentioned earlier. This murky area of S-Corporations is how money can be easily saved. This all comes down to 3 factors - what is your industry, what does your job entail and where are you located? If your business made $100,000 and you compensate yourself $30,000 in payroll as reasonable compensation, this is what will be subject to the individual tax return. Only $30,000 will be subject to federal and state taxes as a single filer, putting you into the 12% tax bracket. The other $70,000 is left in the business that will flow over to you that you will pay taxes on. Flow through entities such as a S-Corp will receive a 20% qualified business income deduction on net income. In the previous example, that means $14,000 is deducted and $56,000 is subject to just federal and state taxes, avoiding self-employment tax all together.
We understand this can be messy and confusing and it is important to contact us to get any questions you have regarding business or self-employment taxes cleared up. Geyer & Associates has been helping Colorado business owners switch from LLCs to S-Corps for decades and we can help you through the same process.