The side project you launched during the pandemic has reached critical mass and is starting to produce real income. Is it best to report what you earn from the business as a sole proprietor and as personal income on your tax return? Or is it time to form a corporation?
The decision to incorporate a business requires significant preparation. But based on your situation, the potential tax savings and growth opportunities offered by an S Corporation (S Corp) could make the move worthwhile.
This article will walk through the key considerations when forming an S Corp and the potential pros and cons of running your business as a corporation. It is meant to serve as introductory guide—before taking action, it is critical to discuss your business plans with your wealth advisor, CPA, and tax attorney.
Tax implications of forming an S Corp.
An S Corp is one of several corporate entities a small business owner can form to gain the protections and tax treatment afforded by incorporation.
S Corps pass through their profits, losses, deductions, and credits to shareholders for federal tax purposes. Owners are considered shareholders of the corporation and report their distributive share of profits and losses on their personal tax returns. This avoids the double taxation on corporate income that occurs with earnings from C Corps, which pay corporate tax on profits while shareholders pay personal taxes on dividends and capital gains. Often, companies decide to be treated as a Limited Liability Company (LLC) and then elect to be taxed as an S Corp.
The biggest tax benefit of an S Corp is the ability to reduce self-employment taxes. Sole proprietors pay a 15.3% tax rate on self-employment income listed on their Schedule C. Income generated by an S Corp can be passed onto shareholders in the form of a combination of taxable salary and profit, which can often be distributed tax free.
Illustration: Tax impacts as a sole proprietor vs. an S Corp
Is an S Corp right for you? If your business is earning $100,000 in revenue, it is worth considering. In the below example, the business owner would realize tax savings of $4,865 by switching to an S Corp rather than filing as a sole proprietor, which would be plenty of savings to cover the additional costs of establishing and managing the S Corp.
|Sole Proprietor||S Corp|
|Employer payroll taxes||$0||$3,559|
|Employee payroll tax||N/A||$3,060|
|Total payroll taxes paid||$11,304||$6,619|
Note: This example is for illustrative purposes only. You should consult with a CPA and tax attorney before changing your business’s tax reporting structure.
S Corps can support growth.
If your business is growing to the point that you need to hire employees, an S Corp has advantages over a sole proprietorship. In addition to the liability protections that a corporation provides against employee actions, it may also qualify for more advantageous payroll, insurance, and related services.
Before making the leap, make sure your business is projected to generate significant and dependable revenue and cash flows to not only make the investment worthwhile but also support long-term operations.
Be prepared for the required legwork.
S Corps must be incorporated domestically, meet a handful of minimum requirements, and file federal Form 2253 with the IRS to qualify for corporate tax treatment. The process involves filing state articles of incorporation and payment of state filing fees. Legal, tax, insurance, and related business operating fees may also be necessary.
Additional requirements you should be aware of include:
- Owners must elect to be treated as an S Corp within 75 days of filing (or within the first 75 days of the year in which the election is effective).
- Once elected, S Corps must file their own corporate tax return, federal Form 1120-S, with earnings reported on a K-1 and sent to the owner(s) for inclusion on his/her tax return.
- Owners must take a reasonable annual salary.
In addition to initial paperwork and fees, S Corps must pay ongoing state filing fees and fulfill other legal requirements.
Don’t go it alone.
Leelyn Smith Tax has helped many clients and small business owners take the next step in their growth by advising on the incorporation process and related tax matters.
We can provide objective analysis on whether it makes sense to form an S Corp or similar corporate entity. We have the advisors you need to help manage the expanded tax obligations and the connections to refer you to attorneys that can assist with legal issues. And because our tax advisors collaborate closely with our financial advisors on a year-round basis, we are well positioned to help you understand how the decision to incorporate could influence your long-term financial planning.
Contact Leelyn Smith Tax today to find out more about the best way forward for your business and how we can help optimize your personal and business planning.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
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