11 MIN READ
When independent financial advisors first start their firms, they typically structure them as single member LLCs (or occasionally as sole proprietorships). A single member LLC, which is a business structure with one owner, has several advantages.
First, it has limited liability. Second, it is usually ignored for federal tax purposes—all the income is reported directly on the tax return of the sole owner. Third, the LLC can make an election to be taxed differently if it wants.
That last advantage is a big one.
After an advisor struggles through that first year or two of acquiring clients and perhaps having more expenses than income, things finally start to turn around. They have built a solid client base and are generating steady income. Reality hits when they realize they're subject to self-employment taxes on their net earnings—a not at all insubstantial 15% tax on top of their marginal tax rate.
Is there a way to control the self-employment taxes and still make money?
Yes, there is, and it involves being taxed as an S corporation instead of a single member LLC.
But before making the switch to an S corporation—which is a separate legal entity from the owner under the US tax structure—to save on self-employment taxes, advisors should know the benefits and limitations of making the election.
How owners are compensated and how certain deductions are handled change, additional tax compliance is required, and future business operations need to be considered.
Changes to How Owners Are Compensated
Instead of taking money from their business account whenever they want, advisors will need to pay themselves a reasonable wage. What was paid annually as self-employment taxes is now taken partly from the employee and part is paid by the company being the employer.
The self-employment taxes have not disappeared—they are broken up and reported differently. The amount subject to these taxes is also limited to what is considered compensation.
This may give them impression that there will not be any savings. Not all the S corporation income is subject to payroll or self-employment taxes. The owner must take a reasonable wage, and then they may report the rest of the business income as ordinary (e.g. not capital gains, and not subject to self-employment taxes).
Defining a “reasonable wage” is a bit of an art because the IRS does not define what that amount is. Obviously not taking a wage at all would not be reasonable. The owner should be paid roughly the same amount an employee would be paid to do similar work.
What happens if the owner pays themselves a low wage and takes the rest of the income as distributions? The IRS may challenge this low wage, and then calculate what they consider is more reasonable; the owner would then be subject to late fines and penalties.
This played out in Tax Court for a real estate agent doing business as an S corporation in 2013. TC Summary Opinion 2013-62 showed the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corporation’s net income of $231,454. He still took home over $130,000 in K-1 income in addition to the salary so avoided some self-employment taxes. The valuation expert used Bureau of Labor Statistics data to determine the average salary for real estate agents in the taxpayer’s zip code.
The morale of this very real story? Proceed with caution when deciding on a low salary as the IRS has means to assess a higher amount.
Owners may also take some distributions like they used to, but compensation should be first. If owners have given, sold, or awarded a piece of the business to employees, then the distributions have to be based on ownership. That means if members have 99% ownership and their employee has 1% ownership, then any distributions need to be in respect of these percentages. The risk of not paying distributions on stock ownership could ruin the S corp election, which would result in the entity being taxed as a C corporation instead, with even more limitations and taxation on most distributions.
Additional Tax Compliance
Instead of a personal return with a schedule C reporting business income, after making the S corp election, advisors will be filing several more returns to report income on their businesses. First, they need to file quarterly and annual payroll reports. If an advisor is successful enough at this point to already have employees, they know the requirements. If this is their first exposure to having to file payroll reports with the federal government and the states they do business in, they may be surprised by the requirements to report and pay at least quarterly through the year.
After making the election, advisors will also need to file form 1120-S that includes a K-1 to report the income and deductions on their personal return. The 1120-S return is due a month earlier than personal return, so there’s no waiting for April to roll around before taking care of their taxes. There is a penalty of $150 per month per owner if the filing deadline isn’t met.
Unlike LLCs that have great flexibility to specially allocate income between the LLC members, an entity taxed as an S corporation must allocate all income to the owners based on share ownership. Income or loss allocations on S corporation tax returns are rigid.
There are limitations on who or what can be S corporation owners. Care must be exercised to not exceed the allowed number of members and to avoid having the wrong type of entity become an owner of the business. For example, there can be no more than 100 shareholders, and only US citizens, resident individuals, certain estates and trusts, and certain tax exempt organizations can be shareholder.
Notice that a partnership cannot be an owner in an S corporation. Sometimes an owner’s estate plan was drafted before the business became an S corporation and the resulting distributions following the estate liquidation could grant ownership to a beneficiary that is not allowed to be an owner in the S corporation.
Changes to How Certain Deductions Are Handled
Advisors who used to wait until their return was prepared to fund the maximum into their retirement plans might be shocked to find that the salary deferral portion of their retirement contribution must be made before the end of the year instead of when the return is filed currently. That’s because employee contributions must come from salary reduction of their earnings in the same year they are earning it. Only the employer matching contributions can be made by the due date of the tax return.
Another difference is how self-employment health insurance is reported. When an advisor was a single member LLC, their self-employed health insurance was an adjustment to income if they had sufficient income, and any excess premiums became an itemized deduction. As a single member LLC, even the Medicare premiums paid through Social Security benefits could count as self-employed health insurance.
Reporting health insurance for an S corp owner has additional requirements. First, the insurance premiums paid from the company are added to the wages on the W-2; then the owner can take the premiums almost like they used to as a single member LLC. Note that the health insurance premiums need to be paid by the S corporation or be part of a reimbursable plan. If this step is missed, the deduction does not qualify.
The home office deduction is very common among small businesses. Until the business makes enough money to pay rent on office space, an area in the home can be dedicated to running a business.
The IRS allows both direct and indirect expenses associated with the office space to be deducted against the business income while operating as a sole proprietor, but there must be profits before taking the deduction. Indirect expenses include a portion of the mortgage interest, homeowners insurance, depreciation on the home, and utilities, all of which become business deductions. Direct expenses include a dedicated phone or fax line and repairs or improvements to the office space itself. Recently the IRS even allowed a simplified approach to the calculation based on $5 per square foot for up to $300 square feet and did not require depreciation being taken nor recovered when the home was sold.
An S corporation does not have a home per se because it is a separate legal entity. An S corporation with this deduction would need a workaround long before the return became due. They could create an accountable plan to reimburse their employees for use of their homes for business purposes, or rent part of the home of employees for home office use.
One might think that because the advisor draws wages after making the S corporation election they can make pretax cafeteria deductions such as dependent care or a health savings account.
According to the IRS, not a chance.
S corporation owners who own at least 2% of the business cannot participate in a cafeteria plan nor pay health insurance on a pretax basis. They will have to make these payments or contributions with after tax funds.
In the past few years, bonus depreciation has become quite generous. Before bonus depreciation, first year election of depreciation (called 179) was used to write off major purchases. Where bonus depreciation is automatic and can now be used for new and used purchases, it used to be limited to only new purchases. Bonus depreciation is not limited to the net income of the business. Passing out 179 on the K-1 is limited to the business income as well as the income of the owner. Care must therefore be exercised when choosing depreciation methods since what may appear to be the best choice at the S corporation entity level may not benefit the shareholder as expected.
The list goes on. Allocations of cell phone plans and auto expenses are also areas that need to be planned around to allow the deduction on the S corp return because the S corporation is separate legal entity.
In the unfortunate situation where there are more losses than income, the S corporation becomes even more confining. The owner may only deduct losses up to their basis in the corporation, including any money they have lent to the corporation. Taking distributions in lean years like this can come with a year-end surprise—distributions in excess of the shareholders basis can result in the distributions being taxed as dividends. Care needs to be taken so the shareholder has basis to take any distributions.
Considerations Around Future Business Operations
Advisors who launch their own firms do not always stay in business for themselves. Some merge, some sell their businesses in whole or in part, and others retire.
Bringing a new owner into the S corporation is as easy as transferring shares to them. If the transfer comes from a sale, the original owner reports gain or loss on sale of the stock. The new owner may want to see the assets and equity of the S corporation reflect what they paid for their stock. Had the entity been doing business as a partnership or LLC, the entity could make an election to adjust the company assets and equity for such a transfer. For many years, the S corporation did not have a similar election so buyers were frustrated that the books did not reflect their purchase or allow them to amortize and deduct the goodwill.
Consideration should be made for selling the business assets instead of the business itself; this works only if 80% or more of the business is sold. In this case, the company buying the assets (or the new shareholder who acquired the at least 80% ownership) can record the assets purchased on the books if certain steps are taken in the year of sale. It is still not as easy as the step up allowed for transfers of LLC or partnership interests, but it’s better than nothing.
There’s also an issue around estate planning. When a sole proprietor or LLC member passes away, all their assets get stepped up or down to fair value. For an LLC, the actual assets get stepped up or down to the date of death values, and the change gets recorded on the books of the business. For the S corp owner, only the stock gets a step up or down, and that change is not recorded on the books of the business—the change in basis is outside of the entity’s books.
Making the election and being able to transfer some of ownership to employees may help keep them engaged and committed to the future of the business. Looking even further into the future, it can be part of the scaling and exit strategy to control self-employment taxes on income as well as future transfers of stock.
Whatever the exit plan, make sure to deal with the final S corporation tax return and any state requirements to end or transfer responsibility for future tax return compliance. California is one state that has a minimum tax to pay until the entity is dissolved, and they have been aggressive in collecting the fee from owners.
Why Not Start the Business as an S Corporation?
An S corporation might be a reasonable business entity if an advisor is spinning off of another entity and would be profitable the first year even taking into account the required owner salary. Otherwise, the losses from the S corporation during the formation business stage would only be exaggerated by the required salary and the additional compliance costs (e.g. additional forms and returns to file).
For these reasons, it is usually best to wait to make the S corp election.
When is the S Corp Election Due?
The election is due March 15 of the year the election is meant to take effect. Thus, if the election is meant to be effective for the 2020 tax year, the due date to make the election is March 15, 2020.
All is not lost if the election was not made on time; there are late filing procedures if certain conditions are met. It is usually too late to make the election after December 31 of the year the election is meant to take effect—filing the tax return electronically becomes more difficult since the IRS is not expecting the S corporation return, and some items like owner salary might not have been paid before year end. This is a case were it’s best to make the election early and start all the additional compliance and payroll at the start of the year.
What Are the Risks of Not Respecting the S Corporation Requirements?
The biggest risk of not following the S corporation rules is losing the S corporation status. At first this might not sound so bad given how confining the restrictions are. The bad news is that the entity does not fall back to being taxed as an LLC. Instead, the entity becomes taxed as a corporation that pays tax on its own net income separate from the owners, and any draws are now taxable as dividends (i.e. double taxation). This happens frequently enough that the IRS has many rules and regulations about what happens during an inadvertent S corporation termination.
Making the S corp election is not just about saving a few dollars on self-employment tax. It’s a step to consider when in the building and scaling phases once the business is profitable enough to pay the reasonable owner salary and still have enough left to cover the additional compliance costs before the remaining income is taxed as ordinary income.
Coming back to the real estate example mentioned earlier, according to the IRS revised calculation, the owner was able to avoid paying payroll taxes on more than half of his income that tax year. For many people, self-employment tax savings on $130,000 of income is significant.
About the Author
Michael Law, CPA, is the managing director of XY Tax Solutions, a wholly-owned subsidiary of XYPN offering an outsourced tax team for XYPN members. Michael has 22 years of experience including time spent as Vice President of Tax Operations at Goldman Sachs. Other hats he has worn throughout his career include Supervising Senior Accountant, Tax Manager, Audit Manager, and Tax Partner.
He's been published or quoted in Accounting Today, Small Biz Daily, Business News Daily, and more. Michael holds a Masters of Science in Taxation from Golden Gate University and a Bachelor of Science in Business Administration from California State University. As Managing Director, Michael will lead our in-house team of tax experts, ensuring the highest standards are met while serving as your in-house team.