What’s so great about the S-Corp anyway?

Hey Ben,

I’m curious to get your thoughts on whether we should be an LLC taxed as partnership or elect to be taxed as an S Corp?

Sincerely,

Mo Money Less Taxes

**

Dear Mo Money Less Taxes,

As always, keep in mind I am not a CPA and you should use this info to get informed and then ask your CPA or advisor what is best for you and how this all relates to your personal tax situation.

An S Corp is set up in recognition of the idea that there are both owners/investors into a company and employees who work for that company. In our example here of a music business, a band business specifically, let’s go full blown caricature. The business owner is the a Captain of Industry with his rotund belly, monocle, three piece suit, and cigar. Then there is the employee, the minion on the the factory floor toiling away for the dollar.

When you choose to take your small business, band business, and have it taxed as an S Corp you are saying to the government that you intend to have both minions and Captains of Industry involved in your business. And in the case of this kind of business, you hold both roles - you are both a Minion toiling away, and a Captain of Industry glaring down at your Minions on the factory floor.

As a Minion you are paid a wage. You are an employee and you receive a W-2.

As a Captain of Industry, you are paid through the profits. You keep expenses and wages down, you increase earnings, and you squeeze more profit out of your business. In this case, as a shareholder you receive a K-1 for your share of the profits. 

As an employee your wages have Social Security and Medicare withheld. A total of 7.65% of every pay check up to $128,400 for 2018, after which SS tax drops off, which is 6.2% of that total, and then it’s just Medicare at 1.45%. The company pays the same percentage but as a company expense. That’s a total of 15.3% "payroll tax.” Then there is also income tax on these wages.

As a Captain of Industry, your profits are taxed only through Income tax. There is no payroll tax on this money since it wasn’t “earned income.” It came about instead, through your gutsy, bold, and cunning business acumen. The minions work for you, you reap the profits! No payroll tax for you then. Right there alone you have 15.3% total savings on these earnings up to $128.400.

Lastly, through the year 2025 there is also a deduction called the Qualified Business Income deduction. New tax law has 20% reduction of income tax on Profits (payment to Captain of Industry).  Your W-2 earnings (Minion pay) will be subject to the full income tax rate.

These are the reasons why people might choose to elect S Corp status. However, there are some other considerations to keep in mind:

You need to be paid a reasonable salary and that amount isn’t black and whie. Most CPAs I’ve talked to suggest at least 50% of your profit be paid as salary (minion pay), leaving 50% as profit distribution (Captain of Industry pay)

Because Social Security tax, which is the majority of the payroll tax, isn’t applied to Wages over $137,700 this S Corp election wouldn’t be helpful if you make approximately $280,000 per year or more since your 50/50 split would have your wage portion already exceeding the maximum Social Security tax.

Also with S Corporations, Unreimbursed Employee Expenses are no longer allowed on your personal tax return. As musicians in a group, if you personally have an instrument buying habit or gear habit that is related to your work as a musician but the S Corp isn’t reimbursing you, then you could lose the deduction of the expense on your tax return. In the case of a LLC partnership, the Unreimbursed Partner Expenses are still active as an option so you wouldn’t have this problem in an LLC.

You can read more on LLCs taxed as S Corps in this excellent essay.

https://www.llcuniversity.com/irs/llc-taxed-as-s-corp-form-2553/