By Paul S. Hamann & Jack Salewski, CPA, CGMA
Planning Season is a good time to sit down with your profitable Schedule C, LLC’s & Partnerships to discuss the potential tax savings of changing to an S Corp. Shareholder-employees of S Corps only pay employment taxes on their Reasonable Compensation versus Sole Proprietors, LLC’s and Partnerships that pay employment taxes on all profits.
When businesses start off small, choosing Sole Proprietor, LLC, or a Partnership makes sense. However, when businesses grow up, it often makes sense to change to another entity type. Making the change to an S Corp can happen at any time of the year, but timing the switch at year-end simplifies life for you and your clients. Your client will start off 2016 with a new entity. No need to file two separate entity returns. Bank accounts can be closed and opened to coincide with the switch. Distractions through the rest of the year will be minimized.
Case Study: Stone Concrete – Why an S Corp Might Be the Better Choice:
Consider the case of Scott Stone, the founder of Stone Concrete, which provides concrete flatwork to residential customers, such as concrete patios, driveways, and sidewalks. When Scott started his business ten years ago, he was leaving a position with another concrete company and striking out on his own. Because he wanted to minimize startup costs, paperwork and compliance complications, an LLC was a good choice back then.
In Scott’s first full year in business, Stone Concrete eked out a small profit of $35,000 on $85,000 in revenue and Scott did it all – sales, pouring concrete, keeping books. Ten years later Stone Concrete has a profit of $225,000 on revenues of $1.2 million and employs eight people.
The key variable in Scott’s decision to change from LLC to S Corp will be his Reasonable Compensation figure. It is very important to use an accurate number at this stage. Going unreasonably low will set unrealistic tax savings and going too high will minimize the potential tax savings. Running a Reasonable Compensation Report shows that a good estimate of the value of services Scott provides to Stone Concrete, based on the responsibilities and the duties Scott performs annually = $70,620
Putting together a simple spreadsheet to illustrate the savings to Scott is a great way to show him how making the switch saves him money, and makes you look like a tax planning rock star.
|Sample Comparison||Schedule C||S Corporation|
|FICA (12.4% on $118,500)||$14,694||$8,757|
|Medicare Surtax (0.9% Over $200,0000)||$6,525||$2,048|
|State Unemployment Tax||$0.00||$300|
|Corporate Tax Preparation||$0.00||$900|
|Sum Payroll Taxes and Additional Tax Preparation Fee||$21,444||$12,005|
Conclusion: Incorporate and elect S status
Additional consulting opportunities usually bubble to the surface at this time. Because determining Reasonable Compensation includes a thorough accounting of all the services a small business owner provides, it’s a prime time, as a Trusted Advisor, to discuss the best use of time and resources, followed by an opportunity for you to offer additional services such as part-time CFO/CEO, strategic planning, payroll and bookkeeping services.