When you own a business, you may hear about electing S-Corporation status. Learn what that means and what factors you may want to consider before making this choice.
Prior to 2018, many small businesses formed an S-Corp once their business made a decent annual profit, over $50,000 or sometimes over $100,000. This is because an S-Corp reduces the social security and medicare tax paid by the business owner. Social security and medicare tax can be as much as 15.3% of business profit for a sole proprietor or LLC business and the opportunity to save 15.3% on a portion of earnings is appealing.
However, in 2018 the tax law changed. Small businesses received a new deduction of up to 20%, significantly reducing income tax for most small businesses. This Qualified Business Income (QBI) deduction applies to pass through income from business. It provides more of a benefit to self-employed businesses, because the deduction applies to the entire income earned from the business. It provides a smaller benefit to S-Corps, since S-Corp owners must be paid a salary and QBI does not apply to owners salary.
Pass-through income: when net income of a business “passes through” to the owner this means it is taxed to the owners on their personal income tax return. The business does not owe any income tax on these earnings.
The result is that while an S-Corp can substantially reduce social security and medicare tax, an S-Corp owner may pay more in income tax. An S-Corp also typically has higher expenses for payroll, accounting and tax preparation fees. The additional income tax and other costs may erode the tax savings entirely.
The best form of business is the one that suits your needs and works for you. The best choice is not the preference of your accountant or attorney, the one they most recommend to everyone else. Professionals are there to help…