I’m guessing that many RV entrepreneurs have heard of the tax savings an S Corp offers. However, it’s important to know when it’s worth electing S Corp status. It’s also important to understand the extra responsibilities of an S corp.
If you’re wondering if you should elect S Corp status, then this is for you.
First, let’s review business entity choices. Remember, that an S Corporation, or S Corp, is actually not a business entity. Instead, it is a tax election that a business owner can choose to use for tax savings. An S Corp separates the owner or owners from the business for tax purposes.
Again, the S Corp is a tax election. How does it offer tax savings?
S Corp Tax Savings
If you recall, a single-member LLC or sole proprietor owner must pay self-employment tax (15.3%) on all the profits of the business. In the case of an S Corp, an owner(s) pay themselves fair salaries (reasonable compensation), and employment taxes are paid on that salary. The remaining profits are passed-through to the owner(s) and the owner is only subject to income tax on these profits. This can help create major tax savings for businesses operating at a profit.
However, it’s not as simple as making the election and you are good to go. There are other things to consider when electing S Corp status.
Also, once you elect S Corp status, you’re sort of stuck for a while. If you decide to change your mind and revoke the S election, the IRS will not allow you to re-elect S Corp for 5 years. Think long and hard about the growth and path of your business before you continue with the S Corp election.
How to elect S corp
As I mentioned earlier, this is a tax election the owner(s) make. A new business has 75 days after the formation to elect S Corp status. This is done by filing Form 2553 with the IRS. It’s pretty straightforward to fill out. You’ll need the business information (EIN and address) and also the owner, member, or shareholder information including social security numbers and percentage of ownership. Most businesses will select the calendar year as a tax year.
If you elect this after the first 75 days have passed, you’ll need to give a reasonable explanation for the late election. Most of the time the IRS approves late election status, so I wouldn’t worry about this too much.
Now that you got your S corp election what are your responsibilities?
Extra responsibilities of an S Corp
An S corp MUST pay its owners or shareholders reasonable compensation. This is probably the single most important consideration when electing S Corp status. The IRS will audit a business specifically looking at reasonable compensation and many times tax court has ruled distributions as reasonable compensation. This means extra penalties and possibly interest on unpaid payroll taxes.
I would make sure you are paying yourself and any other shareholders reasonable compensation for work done in the business. Coming up with a salary is no easy task. You’ll want to consider the geographical location, your title and responsibilities, and how much time and energy you are putting into the business. You should also consider your experience within a field. Typically I say it’s best to have written back-up of why you are paying certain salaries to your claim on reasonable compensation.
Paying salaries means the business is responsible for payroll taxes and reporting. This includes unemployment tax, income tax withholdings for both federal and state and also paying the business share of Medicare and Social Security. These extra reporting responsibilities can be made easier by using a payroll service. My favorite is Gusto. It will automate payroll and file all necessary payroll reports for you after you have signed up for the necessary accounts with the right government authorities.
Payroll also means you need to file year-end W-2 reports with the IRS and state, if applicable. You would provide the W-2 to yourself as well to use on your personal income tax return.
However, payroll comes at an extra cost and should be taken into consideration when determining if S corp offers you savings or not.
Separate Tax Return
An S corp must file an informational return as part of its obligations. This is Form 1120S and is filed separately from your personal Form 1040. It is also due March 15th vs. April 15th and can file for an extension until September if that’s needed.
This form is where the S corp reports all income, salaries, expenses, and also the basis for each business owner. The S Corp tax return produces a K-1 which is used on your personal return.
If the 1120S is filed after the deadline, the IRS charges each owner a late-filing penalty in the amount of $195 for each month, or part of the month, that the return is late for up to 12 months.
Filing a separate tax return is another responsibility of an S Corp and an important one at that.
3 Advantages of an S Corp
Up to now, we’ve only gone over the responsibilities of being an S Corp. Now let’s get into the fun stuff, the tax savings!
Being an S Corp offers you the choice of contributing to a Solo 401k or a SEP IRA. The tax savings of retirement contributions is a serious thing to consider in any business. However, as an S Corp owner, you get to deduct any employer contribution as an expense of the business. Plus, contribution amounts can be up to $57,000 for 2020. It’s not quite as simple as contributing $57,000, so I highly suggest you talk to a tax professional to understand your specific contribution limits.
Generally, the company can contribute up to 25% of your W-2 salary towards retirement savings. You can then make up the difference as elective contributions on your own. Again, I recommend talking with a tax professional to understand your specific situation. This isn’t a one size fits all.
As a more than 2% owner of an S Corp, the company can pay for your health insurance. Bonus!
Let’s dive a little deeper into the deduction for health insurance costs for S Corp owners so you fully understand it.
When your S Corp pays your self-employed health insurance, that amount gets added to your salary on your W-2. I know. I know. It sounds like your wages are getting increased by your health insurance premiums. Rest assured this is taken care of further down on your personal income tax return (Form 1040).
Also, know that it is only your personal wages that increase. Increases are not made to your Social Security or Medicare wages, so there will be no additional employment tax owed for the health insurance premiums.
Next, your self-employed health insurance premium reduces your taxable dividend income from your S Corp. By this I mean it comes off your S corp income that is passed through to you as the owner, so now you have less dividend income. Therefore, you’ll owe less personal income tax.
Now let’s address the addition to your W-2 wages. Since you are considered self-employed as a greater than 2% shareholder of your S Corp, you get to take the health insurance premium deduction on your personal income tax return (Form 1040). This is an exact dollar for dollar reduction in your gross income.
Let’s go over this one more time so that you understand this concept. The deduction and tax benefit of self-employed health insurance is done on your business informational return (Form 1120S). The deduction will then appear on your individual tax return Form 1040. As a self-employed individual paying for health insurance, you should have an entry and deduction on your personal income tax return. If you don’t, check in with a tax professional for help on this issue.
Although you get an artificial increase in your wages by the amount of your health insurance premiums, Social Security and Medicare taxes are computed on the smaller amount (the actual salary you pay yourself). Plus, you’ll receive a slightly smaller dividend from your S Corp, which means you’ll owe less personal income tax. Make sense now?
As a reminder: health share ministry payments do not count for the self-employed health insurance deduction.
Self-employment taxes savings
Remember how we talked about the self-employment tax obligation of a sole proprietor. This the Social Security and Medicare responsibility of being a sole proprietor. It’s an automatic 15.3% of your business net profit going towards that self-employment tax even if you owe no federal income tax. In the case of an S Corp, the self-employment tax does not apply. Here’s why.
You are paying yourself a W-2 salary which means you get the Social Security and Medicare tax taken out of each paycheck. This also means you only pay half of these taxes yourself. The business gets to take the other half as an expense. This lowers your business net profit and therefore, your dividend at the end of the year.
Your salary is also a deduction for the S Corp which again lowers the net profit of the business.
This means you do NOT pay self-employment on any of the business net profits at the end of the fiscal year. This is a savings of 15.3% of any net profit after your salary, payroll deductions, and the usual business deductions.
Can you see the savings yet?
Let’s take a look at an example.
If your business has a net profit of $100,000 in a year, then this is what your tax savings could look like as an S Corp vs. a sole proprietor. Your savings would be $3,825 in one year!
Your savings could be great if you contribute to a retirement plan, earn more income, and qualify for other deductions or credits.
What about if you spend your own money on certain expenses?
Reimbursements for business expenses
As an S Corp, you should establish an accountable plan. This simply means you should have written documentation for all expenses that the company reimburses you for. Plus, you should request reimbursement within a set amount of time (say 30 days or something similar). This sets a plan out for not just you as an employee, but anyone else you might hire who incurs business expenses personally.
This can include cell phone costs, meals with a client, miles driven for business, or any other expenses for which you didn’t use a business account.
I suggest having a spreadsheet to document these expenses. You should include the date of the expense, the amount, the purpose, and then also the date you were reimbursed by the company.
Also, make sure to have your receipts for these items and a mileage log for any business miles driven. This is a great way to get any business miles on your personal vehicle paid for by the company.
Implementing an accountable plan in your business will not only add deductions to your business but also make sure your own personal money is not being spent on business expenses. It’s a nice little bonus and an easy way to make sure all expenses are counted on the business books.
If you plan to have an S Corp, then you also need a separate bank account with no personal expenses taken from this account! This truly helps separate you from your business. It will also show the movement of the reimbursed expenses to your personal account.