It seems I have paid the government more than what was necessary over the past few years. When I first started earning money outside of my primary employer in 2004 or 2005, I assumed it would make the most sense to simply claim that income as self-employment income on Schedule C of the standard 1040 income tax return. It wasn’t such a bad idea; there was not a lot of paperwork involved.
When my business was growing, I decided I should formally accept that I had a business, so I registered as a limited liability company (LLC) and received a employer identification number (EIN) from the federal government. I also registered with the State of New Jersey. Although the business was now formalized, I could file my income tax return using Schedule C. Single-owner LLCs can be considered sole proprietors, too, so I continued using simple paperwork.
A few months ago, I finally got around to meeting with the accountant who had been recommended to me by a friend who has owned his own business since 2000 and who has written guest articles for Consumerism Commentary twice. We talked quite a bit about my situation and my business and he recommended filing as an S-corporation rather than a sole proprietor.
The biggest benefit of the S-corporation is the ability to significantly reduce payroll taxes. From what I understand, as owner of the company, I would not need to take all income from the business as personal income every year. I can withdraw only what I need or want from the business account, use that amount for determining the income tax owed, and leave the rest alone.
By reclassifying my business in 2008 as an S-corporation, the accountant, who charges $500 per year’s return, was able to save me about $10,000 between federal and state taxes. I have not yet received the refunds, however, so my fingers remain crossed. Unfortunately, we could not reclassify the business to an S-corporation for 2007, but the accountant made some other business-related adjustments and we found about $5,000 more.
I received the first refund check from the State of New Jersey for my amended 2007 return yesterday. As long as the other checks come as expected, working with the accountant was very worthwhile.
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It’s a shame this article doesn’t have a “like” button, like in Facebook.
Yes, the benefit of S-Corp taxation is that distributions of S-corp profit are not subject to self-employment tax (as compared to sole proprietorship profits, which are). The only catch is that you have to pay yourself a “reasonable salary” before you can take such profit distributions. (And that salary will be subject to payroll taxes, which in total are equal to the SE tax.)
So, your net savings end up being roughly equal to 15% of your profits beyond a “reasonable salary” amount. Here’s a video/article I wrote on the topic a while back. It’s a rather technical topic, but the potential for savings are huge.
Congrats on the effective pay raise! :)
How did you manage to reclassify for 2008? The deadline is March 15th of the year in which you make the change unless there was a clerical error. In other words, you should have made that election by March 15th, 2008 for the 2008 tax year. While I could see making the 2009 election this late in the year, it seems like a stretch to go all the way back to 2008 — or am I missing something?
Nickel: I had to pay a penalty to the state, but apparently if you ask, they’ll allow it. Check out Section 2 (2) in this IRS Revenue Procedure. They only allowed it for 2008, not 2007.
From that pdf:
“Attached to the Form 2553 must be a statement explaining the reason for the failure to file timely the S corporation election and a statement explaining the reason for the failure to file timely the entity classification election.”
What was your reason?
I’ll have to check my paperwork next time I’m home.
To clarify, did you convert the business itself to an S-Corp or are you still an LLC opting to be taxed as an S-Corp? I’m thinking of doing this myself, although my business income probably isn’t quite high enough to benefit yet.
Could you explain what the “other adjustments” were that saved another 5K?
Wow. Worth his weight in gold, eh? Wish I had a $15,000 business error!
I am glad I did not have a $15k error, personally. But if one is out there I would wish I had found it.
I know Laura Langemeier from Live out Loud is big into setting up S corporations, but I get lost in the legalities of setting one up. Of course, there is no need for me to do so at this time, but if and when that time comes than I will hire someone to handle such needs.
You have yourself a great accountant. Like a good hairdresser, do not let the accountant go! Now if only I could find me a $15K return. ;)
Imagine if you talked to someone years ago? That is why I never understand why people insist on using those online garbage will programs, or to a lesser extent why so many are anti-investment professionals. Why because they charge a fee? So did the Accountant.
Great information, Flexo, and great follow-up, Mike. The S-Corp can potentially save business owners serious money but they are not the right vehicle for every business and they are less flexible in their administration than the LLC. As Evan said, that’s why people pay their accountants.
We are organized as an LLC, but we file as an S-Corp – since the LLC is not a recognized entity by the IRS, your options are either sole proprietor or S-Corp when you file. Once you’re making more than a “reasonable salary,” it’s more beneficial tax-wise to elect the S-corp filing. I’m not at the point where I want to actually *be* an S-Corp.
Congrats Flexo! Is there an income dollar amount threshold you think one should pass before setting up an S-corp? Maybe $20,000/yr? Or ASAP no matter what?
It’s definitely not ASAP. Nor is there really a magic number, reason being that the “reasonable salary” figure is a function of factors such as hours/week devoted to the business and what type of business it is. You can find more info here:
http://www.irs.gov/newsroom/article/0,,id=200293,00.html
OK, sounds good. Im just thinking about from an immediate cost benefit point of view since Flexo mentions he spent $500 for his tax accountant. Obviously if you are making only $500-1,000/yr, that’s probably not worth it, so just wondering what a better figure would be to start thinking about doing an S-Corp.
To answer a few more questions… the IRS permitted a 2007 reclassified from sole proprietor to partnership which saved additional money when the s-corp reclass wouldn’t have been allowed (too late). They permitted the late 2008 reclass to s-corp because it was my first time filing as such and they granted leeway but seemed to imply such lenience wouldn’t be available for me again.
As far as the difference between a “true” s-corp and an LLC filing as an s-corp, I’m not sure, but since the IRS assigned a new EIN with a 30 prefix, that may make the business a full-fledged s-corp. He also says the business should now include “Inc.” in the name rather than “LLC.”
I have a question on this.
I recently spoke to a tax preparer on this issue. She told I was required to do books for my S Corp. I am a single owner LLC classified as S Corp. I pretty much only have income derived from invoices and other expenses such as perdiem, etc.
Do you think I should do those books? Is there a simple alternative than Quick Books that she suggested. What do you all think?