Your a single member LLC business. Mid-year… after the initial shocker of the Federal tax balance has finally settled in your stomach, you vow to yourself that you are going to do a better job on your tax return for the next year.
Your first instinct is to do a better job of tracking expenses for your business. You download one of those nifty mileage trackers on your phone because you are convinced that you are missing dubious amount of mileage and that is going to be the easiest way to find more “deductions”. Unfortunately that idea goes out the window when you realize that your battery is dead twice a day because you have the leave the app running all day long. The next thing you do is lower business income is that you decide that you need to buy some equipment for your business but quickly realize that you should not have spent all this money to lower your business income, because really…. you need the income to pay for operating or person expenses.
You think, what’s a business need to do to save some money on their taxes. This is where a savvy CPA can advise you.
A quick and easy recommendation is to convert your business to an S-Corporation. With this type of entity designation, you are able to get the liability benefits of an LLC and the tax benefits of a Corporation.
Among the many benefits in this designation, the main one that I want to discuss are those that relate to the avoidance of the dreaded Self Employment Tax!!!! Duh Duh Duh! Here is the math behind the cost savings given the example of a single member LLC business earning $33,000 net income per year:
- If you are a Single Member LLC, the IRS does not recognize this formation as a separate entity for tax purposes. It is what is called a Disregarded Entity.
- At the end of the year when you report this income on Schedule C of your personal tax return, you are hit with Self Employment Tax (15.3%) on the net amount that you take home from your business. The total of the self employment tax that you will pay on $33,000 will be $5,049.
- In addition you will also be taxed at your normal tax rate for all of that income as well. For $33,000 this represents another 15% or $4,950.
- Your total tax will be approximately $10,000!
- If you are set up as an S-Corporation, there is some paperwork that can be done on the back end that will save you a lot of money in the long run. With a Single member S-Corp, the business is it’s own entity (that requires a separate tax return) and it is the business that pays you (the sole owner) a “reasonable” salary. Keep in mind the salary is all on paper and you would still be taking out the same amount of money out of your bank account that you have in the past. For this example the business pays you a salary of $20,000 (on paper).
- Therefore throughout the year you would be paying payroll taxes on the wages/ salary that you are paying yourself. On a $20,000 this represents $3,060 in payroll taxes.
- However, this 20,000 will also be a deduction on your business income and as well as ½ of the payroll taxes that you have paid, and this would lower your net income from the original $33,000 to $11,470. Then at the end of the year you would report on your tax return the “salary” that you have paid yourself of $20,000 (represented through a W-2) plus your business income of $11,470 for total income of $31,470. The normal tax rate of 15% would again apply to the total amount for a tax of $4,720.
- The total tax that you would realized for the year would then equal the $3,060 plus the $4,720 which equals $7,780. By making the S-Corp election you can save approximately $2,220 based on the $33,000 income example.
** Caveat to all of these calculations is that that I am only speaking about Federal Taxes and this does not include the tax ramifications of state taxes
So what are you waiting for, GO S-CORP! Or don’t and keep paying self employment taxes.