Converting to an S-Corp will save me money, right?
Maybe it will, maybe it will not.
This is a question I hear at least once a month. Typically, small business owners ask me this question after being told by family, friends, and perhaps even an unscrupulous tax return preparer or two that they will save "a bunch in taxes" by converting to an S-Corporation.
What’s the play?
S-Corporation pass-through income is not subject to self-employment taxes. Self-employment tax is levied on LLC* member-managers' and sole proprietors' self-employment income as a way to fund Social Security and Medicare. Because S-Corporation pass-through income is not subject to self-employment taxes, they must be paid “reasonable wages” from which Social security and Medicare taxes will be withheld and for which the S-Corporation will pay the other 6.2% social security and 1.45% Medicare tax as deductible payroll taxes.
Therefore, if the business owner pays him or herself a lower wage, he or she can allow income to pass through to his or her personal tax return, thereby avoiding payroll taxes. Often, business owners are told to pay themselves wages of, say $50,000, and let the other $150,000 of income pass through to their personal tax returns on Schedule E.
This is an awful idea.
If the owner pays him or herself an artificially low wage, he or she will save Social Security and Medicare tax. Until the IRS comes knocking.
A quick review of the case law returns more than 500 court cases where the IRS has challenged the reasonability of S-Corporation shareholder wages. The IRS is very often successful in recharacterizing portions of these taxpayers’ distributions to wages. It's an easy catch for the IRS, and an even easier case to win, because nobody would be able to argue that $50,000 of wages is reasonable considering the company's income. Perhaps worst of all, the penalties and interest associated with a substantial recharacterization can be significant, and they are nondeductible.
Small companies also need to be aware of the additional recordkeeping requirements, payroll filings, and restrictions they’ll face upon conversion to an S-Corporation. If you own a sole proprietorship or single member LLC with no employees, it is likely operating at its highest efficiency from a cost of compliance standpoint. If you convert your single member LLC to an S-Corporation or set up a new S-Corporation, you will be required to keep records of shareholder meetings and dividends declared, engage a payroll service, and file separate tax returns for the entity and its payroll. You'll also be limited on the number of shareholders, type of shareholders, and way you allocate income. This could create problems if you ever decide to bring in outside investors or implement an estate plan.
These limitations and additional costs, combined with the fact that you’ll be required to pay yourself reasonable wages, subject in effect to the same taxes you’d pay on your self-employment earnings, make the idea of saving “a bunch in taxes” by converting a small company to an S-Corporation a bit dubious in certain cases. At the end of the day, it doesn’t make sense to pay $3,000 in professional fees every year to save $2,000 in payroll taxes. Often, lack of understanding causes small businesses to do just that.
What should I do?
Before you decide to change the structure of your business, make sure you understand all the ramifications of your decision. S-Corporations can be a fantastic business structure for the right set of facts and circumstances. Talk to a qualified professional who will walk you through your decision - if your current tax professional's advice sounds too good to be true, it probably is.
Do you need help making your business structure more tax efficient? Are you not receiving the level of service you need? Let's have a conversation. Call me at 513-554-4600 or e-mail me at email@example.com; I would be glad to help.
*For the sake of brevity, assume any multi-member LLC discussed in this blog post is taxed as a partnership