The S Corporation: A Smart Move for Sole Proprietors and Single-Member LLCs

For small business owners, reducing tax liabilities is crucial to maximizing profits and keeping more of their hard-earned income. Sole proprietorships and single-member LLCs (Limited Liability Companies) are popular structures for entrepreneurs due to their simplicity and autonomy. However, both are subject to self-employment taxes, which can take a significant bite out of earnings. Electing to be taxed as an S corporation (S-corp) can be a game-changer, offering substantial tax savings while maintaining flexibility in how the business operates.

Why Self-Employment Taxes Matter

If you run a sole proprietorship or single-member LLC, your tax obligations go beyond regular income taxes. You're also responsible for self-employment taxes, which fund Social Security and Medicare. The current self-employment tax rate is 15.3%, applying to your entire net income up to the Social Security wage base.

For example, if you earn $100,000 in profit as a sole proprietor, $92,350 of that income is subject to self-employment taxes. This results in a tax bill exceeding $14,000—on top of your regular income tax.

How S-Corp Election Reduces Self-Employment Taxes

Choosing to be taxed as an S-corp offers a legal way to lower your self-employment tax liability. Here’s how it works:

• Salary vs. Distributions: As the owner of an S-corp, you are required to pay yourself a reasonable salary based on the work you perform. Only this salary is subject to payroll taxes (Social Security and Medicare), while the remaining business profits can be taken as distributions, which are not subject to self-employment taxes.
• Reduced Tax Liability: By splitting your income between salary and distributions, you reduce the portion of your income that is subject to self-employment taxes. For example, if your business generates $100,000 in profit and you pay yourself a salary of $50,000, only that $50,000 is subject to Social Security and Medicare taxes. The other $50,000, taken as a distribution, avoids self-employment taxes, potentially saving you thousands each year.

Example of S-Corp Tax Savings

Let’s say a business owner earns $100,000 in net income as a sole proprietor. They would pay $14,130 in self-employment taxes, plus income taxes.

Now, if the same business elects S-corp status and the owner pays themselves a reasonable salary of $50,000, they would owe payroll taxes on the salary alone ($50,000 x 15.3% = $7,650). The remaining $50,000 taken as a distribution avoids self-employment taxes, resulting in a savings of $6,480.

How to Elect S-Corp Status

If you’re a sole proprietor or single-member LLC, electing S-corp status requires a few steps:

1. Form an LLC: If you haven’t already done so, you’ll need to form an LLC to protect your personal assets and provide your business with a formal legal structure.
2. File IRS Form 2553: To elect S-corp status, file Form 2553 within two months and 15 days of the start of the tax year. If you miss the deadline, you may be eligible for late filing relief under certain conditions.
3. Pay Yourself a Reasonable Salary: The IRS requires S-corp owners to pay themselves a “reasonable salary” based on the work they perform. This amount should be comparable to what others in your industry or region earn for similar work.
4. Handle Payroll: You’ll need to run payroll and withhold the appropriate taxes for Social Security, Medicare, and federal income taxes. Using a payroll service like Gusto can help manage this process.
5. File Business Tax Returns: After electing S-corp status, you’ll need to file an annual corporate tax return (Form 1120-S) along with your personal tax return. Your salary will be reported on a W-2 form, and your distributions will be reported on your personal tax return.

Considerations and Potential Drawbacks

While electing S-corp status can lead to significant tax savings, there are a few important factors to consider:

• Administrative Costs: S-corp status comes with added administrative responsibilities, such as managing payroll, filing quarterly payroll tax reports, and preparing an annual corporate tax return. You may need a CPA or payroll service to handle these tasks, which adds to your costs.
• Reasonable Salary Requirement: The IRS scrutinizes the salary you pay yourself. If your salary is deemed unreasonably low, the IRS may reclassify some of your distributions as wages, leading to back taxes, interest, and penalties.
• State Taxes: Some states impose additional taxes on S-corps. For example, California has a 1.5% franchise tax on S-corp income, which could offset some of your savings.

Is S-Corp Status Right for You?

If your business generates more than $50,000 in net income, electing S-corp status may be worth considering. The tax savings from reducing self-employment taxes can often outweigh the added administrative costs. However, it’s essential to assess your specific situation and consult with a tax professional to ensure you meet IRS requirements and that the tax benefits make sense for your business.

Conclusion

For sole proprietors and single-member LLCs, electing S-corp status can be a powerful strategy to reduce self-employment taxes. By splitting your income between salary and distributions, you can significantly lower your tax bill and keep more of your earnings. While there are additional administrative tasks to manage, the potential savings can make S-corp election a worthwhile decision for many small business owners.

Schedule an Appointment

If you’re interested in exploring whether an S-Corporation election could work for your unique situation, don’t hesitate to schedule an appointment. Contact Stella Sanchez, CPA for more information. Let’s work together to create a tax strategy that maximizes your income while minimizing your tax burden.