S Corporation essentials for tax pros

S Corporations can offer tax reduction benefits, but they come with specific requirements that tax professionals and their clients must be aware of. It’s not just about making an election and filing a different tax return; it’s about understanding the implications and ensuring compliance to avoid IRS complications.

What is an S Corporation?

An S Corporation is not a legal entity; it is simply an election to be taxed differently. The impact of the election is that the business income, loss, deductions, and credits flow to the shareholders and taxed on their personal return. In other words, the business does not pay federal income taxes. One of the biggest advantages of this entity choice is that the pass-through income avoids self-employment taxes.

Although these are not all the advantages and disadvantages, they are important items to consider before deciding to be taxed as an S corporation.

S Corporations vs. LLCs

It’s important to note that for tax purposes, a Limited Liability Company (LLC) is treated the same as a Sole Proprietorship or Partnership, since it is a disregarded entity. Both LLCs and S Corporations offer similar tax deductions and benefits. The primary distinction is that S Corporations can avoid self-employment taxes on residual income after accounting for reasonable compensation, leading to a potential tax savings of 15.3%. See Table 1.

The biggest difference between the two entities is that an S Corporation election avoids self-employment taxes on any income remaining after taking reasonable compensation. This can save 15.3% in taxes.

What is self-employment tax?

Self-employment tax encompasses Social Security and Medicare taxes. Being self-employed means you’re the employer and employee, resulting in a combined tax of 15.3% on net income, excluding other taxes.

As you can see in the table above, when you are self-employed, you end up paying a total of 15.3% in self-employment taxes on your net income— income after expenses—and this does not include federal or state income taxes!

Now let’s take a closer look at a scenario that illustrates the taxable difference between these two entities shown below in Table 3.

You can clearly see the benefit of electing to be taxed as an S Corporation in this example: Based on the assumptions, this income level results in a tax savings of $3,060. As income rises, the potential tax savings increase.

Break-even point

So when does it make sense to make the S election? While it depends on many factors, the first indicator is when self-employment tax exceeds the cost of compliance. In other words, when the tax savings are equal to or more than the costs to operate as one.

I know you’re probably thinking, “Why would anyone become an S Corporation if the tax savings are equal to the cost to operate as one?” Well, this means that instead of paying tax to the government they are able to get their accounting services for “free,” so to speak. That is, instead of paying tax, they will pay for accounting services that adds value to their business.

Depending on other factors such as state minimum fees, the break-even point could be higher or lower based on the state you live in.

Once you figure out the tax savings—after reasonable compensation is determined—you can use Table 4 to input the difference fees and costs involved to calculate the total net savings of the election.

The cost savings calculation is as follows:

Tax Savings – Accounting Costs – States Fees – Other Costs = Net Savings

If there are any additional costs that are required and have not been discussed, you can place them in the “other costs” column. Do not include one-time fees or expenses in your calculation since this will not reflect your actual savings per year.

Using this calculation can be a great way to add additional services and boost your bottom line while helping your clients. One way we do this is to show your clients that by not making the election, they will end up paying more in tax. Even if they are just breaking even, they could end up getting their accounting and tax services “free” instead of paying the tax man each year.

S Corporation complications

While tax savings are evident, especially with increasing income, there are potential pitfalls to consider:

• Income consistency.
• Varied distributions among partners.
• Cash flow management.
• Ensuring reasonable compensation.
• Tracking basis.
• Maintaining records.
• Potential conversion issues.

It’s crucial to evaluate the overall benefits and challenges holistically. If a business isn’t operating with diligence and professionalism, the complications might outweigh the benefits. Factors like consistent income, proper cash management, and meticulous record keeping are essential considerations.

Put on your tax advisor hat

S Corporations present a tantalizing option for businesses, offering notable tax advantages and operational benefits. However, like all financial decisions, it’s not a one-size-fits-all solution. Tax professionals play a pivotal role in guiding their clients through the intricate maze of rules and regulations, weighing the pros against the potential pitfalls.

By adopting a holistic approach, considering the immediate tax savings and the operational challenges, you can ensure your clients make informed decisions that truly benefit their business’ bottom line. As always, the key lies in understanding, meticulous planning, and proactive management.

In part 2 of this series, we’ll dive into more information you should know, and include some helpful tips to assist your clients and practice.

S Corporations: Everything You Need to Know

Looking to expand your understanding of S Corporations? I’ve crafted resources specifically for tax pros like you! Dive into the intricacies of S Corporations regulations, tax benefits, and potential challenges in our course and eBook that offers expert insights and actionable strategies. It’s designed to empower you with the knowledge to advise your clients effectively, and navigate the complexities of this unique business structure.

Use coupon code TAXPRO to get 20% off any of our courses and materials.

Editor’s note: Part 2 of this series can be found here.