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3 Factors to Consider BEFORE You Become an S-Corporation

3 Factors to Consider BEFORE You Become an S-Corporation

You might have seen or heard somewhere that making the S-Corporation election for your small business can save you tax dollars.

It can.

But before jumping into an S-Corp, there’s a wealth of legal paperwork and formality. Take some time to consider whether this is really what you want, and contact us if you need some help deciding.

We’re going to look at three major areas of inquiry when it comes to determining whether you are ready to make the step towards incorporation.

Is Your Business Income and Cash Collection Steady?

Owners of S-Corporations are also employees. As employees, the owners (including you) must draw a regular salary. It can be a once-a-month salary for simplicity’s sake, but it’s important to determine ahead of time if you have the income and cash flow in order to do this.

But aren’t income and cash flow the same thing? Well, they’re similar concepts but not the same.

Net Income is a determination of the health of your business. If income is positive, you’re taking in more than you’re spending. But if you have some suppliers who have owed you money for 3 months and it’s affecting your ability to pay your rent, then you have an understanding of the difference between net income and cash flow.

In short: Income means that your company looks good on paper and is probably healthy, but cash flow is about when the cash actually hits your bank account after you collect it from your clients or customers versus when you pay suppliers and other vendors.

You want to have a high enough income in order to pay yourself a salary; if you don’t, you’ll run out of cash in the long run. You also need the cash flow to pay yourself a salary, or else you’ll run out of cash in the short run.

If you can’t afford to pay yourself a salary, it’s not yet time to make the S-Corp election.

Are You Keeping Your Books Up-To-Date?

When you incorporate, your books become more complex. Right now, if you need money from your business, you might just take the occasional distribution. After incorporation, you will be looking at payroll expenses, withholdings, special restrictions regarding accountable plans, and other legal and regulatory hoops to jump through. In order to keep track of all this, you will probably want to use payroll software. We recommend Gusto.

Because making the election leads to more complexity in your books as well as the requirement to use a payroll package, you want to make sure that you’re able to get a solid grip on your books as they are now. Upgrades always go more smoothly when you start from a good position, and beyond that, you want to make sure you have the skills and time to keep your books now before you try to tackle S-Corporation bookkeeping.

If this sounds like a lot of work, but you still want those sweet tax breaks, then consider hiring us to set you up. We’ve set up other clients as S-Corporations, and we can do yours too.

But of course, beyond looking at whether you can be an S-Corp and whether you’re ready, it’s important to ask if it’s even worthwhile.

Is Making an S-Corp Election a Good Idea?

Before we get into the pros and cons of an S-Corporation, let’s not get ahead of ourselves. Are you an LLC (Limited Liability Company) or PLLC (Professional Limited Liability Company) right now? If not, then the first step is to become an LLC, a simplified corporation with little formality. Becoming an LLC will give you limited liability protection.

Limited liability protection is the benefit that, as long as you follow the rules, there is a “wall” between your corporation’s property and your personal property. If someone sues your corporation, this “wall” (known as the “corporate veil”) will keep them from being able to acquire any of your personal money or property.

Once you become an LLC or PLLC, or if you already are one, let’s look at some pros and cons for becoming an S-Corporation. In accounting we call this an election to be treated as an S-Corporation for tax purposes. By default, your LLC is taxed as a sole proprietorship or partnership depending on whether or not it’s a single-member LLC (a married couple can count as a single member in a single-member LLC). Single member LLCs may also be shown as SMLLC or SMPLLC.

Pros and cons of an S-Corp election vs. filing as a Single Member LLC

Pros:

  1. Major pro: Avoiding self-employment taxes
    1. Unincorporated businesses must pay self-employment tax on earnings. That is to say, instead of paying 7.65% of your paycheck in FICA taxes like an employee, you must pay 15.1% which is the employee’s half and the employer’s half. This is a downside of “being your own boss.”
    2. As an S-Corporation, the distributions you take from the corporation are exempt from FICA payroll taxes. The salary you take from the corporation will have payroll taxes on it. Still, this can save you money overall.

Cons:

  1. Con: Complexity
    1. Perhaps the biggest con for a small business owner when electing for S-Corporation is the formalities and frustration involved with upgrading your business into a more formal legal entity – this depends on the state you are in.
    2. Specifically, you will be required to file a separate tax return for your S-Corporation, which you should not file on your own. In addition, you will need to file payroll returns as well.
    3. Not only does electing as an S-Corporation cost you fees, but you will also be required to make more regular filings going forward, costing more fees. Hopefully you’re saving enough money from reduced payroll taxes to break even on these fees.
  2. Con: Salary subject to IRS discretion
    1. Here’s something we haven’t covered yet in this article: How do you know what the right salary is for yourself? Normally this isn’t an issue because the boss and employee are two different people. But when the boss and employee are the same person, the IRS can scrutinize the salary amount to determine whether it is reasonable.
    2. If you’re wondering why this matters, think about this: If you don’t pay any payroll tax on distributions, then you have an incentive to run all your compensation as distributions and none as payroll. The IRS doesn’t like this because part of being an S-Corporation is treating yourself like you are an employee of the business.
    3. Determining a reasonable salary involves research, planning, and some math. We can help you in this process!
  3. Con: Restrictions on investors
    1. If your plan is to sell equity (ownership portions of your company) to investors in return for investment capital to buy property or equipment or make another kind of major cash purchase, bear in mind that there are restrictions:
    2. S-Corporations have a maximum of 100 shareholders, who all must be US Citizens or residents, and cannot be corporations or partnerships.

So when it all boils down, the real question is: Are the tax savings worth taking the plunge? Many business owners think so and an S-Corporation is a very popular entity for small businesses. Will your business be the next new S-Corporation?

TL;DR: Do you have the resources to pay yourself a salary? Are your books clean? Will upgrading to an S-Corporation pay for itself by reducing your taxes? If the answer to all these questions is Yes, then maybe it is time for you to make the election! If this sounds intimidating, remember that you are not alone. Give us a call!

Schedule your first call with one of our team members here.

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