Editor's Note: This story has been corrected to include the ability of tax filers to write off rental losses against Sub S income. The original included misinformation provided by the IRS. Please click here to read the updated article.
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When you become self employed, you must decide what form of business entity to establish. The basic categories include: sole proprietorship, partnership, C corporation, LLC (Limited Liability Company), and S corporation.
It’s important to discuss entity selection with both your attorney and your tax pro, before deciding what structure is best for your business. Each option offers advantages and disadvantages, so don’t take the decision lightly. Every business situation is unique and requires a full study to make the most beneficial determination.
Below are some of the advantages and disadvantages of the Sub S corporate structure, but do not just run with my ideas thinking you’ve found the best solution-- unless you are running straight to both your tax pro and your attorney to discuss further.
Also remember, most attorneys (unless they’re a tax attorney) do not know tax law backward and forward and a tax pro should not be sought out for legal advice. These are separate fields and both professionals have enough knowledge of the other’s just enough to be dangerous.
With that in mind, let’s explore.
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But first, one more aside: If you select an LLC business structure, you can elect to be treated for tax purposes as any of the above entities. At the federal level there is no tax return for an LLC--it’s what you call a check-the-box entity. If, as an LLC, you elect to be treated as a sole proprietorship, you will file a Schedule C with your individual income tax return, if a partnership you will file a Form 1065 –partnership income tax return, if a C corporation you will file a Form 1120 corporate income tax return, and if you elect sub S corporation, you will file a form 1120S, sub S corporate income tax return. The tax rules regarding whichever entity you select for tax purposes will apply to your LLC.
When you file your incorporation papers, you must remember to complete Form 2553 to elect treatment as a sub S corporation. I have seen a failure to file mistake made many times. A business owner sets up the corporate paperwork with his attorney. The tax pro isn’t in the loop and the form isn’t filed timely with the IRS. The IRS then classifies the corporation as a C corp, applying the rules for that entity, which may unnecessarily cost the taxpayer thousands of dollars in taxes. Fortunately, the IRS has taken a more lenient attitude in the past several years, allowing taxpayers to late file the form and make it retroactive to the origin of the corporation.
As a sub S corporation, you as the owner/operator will have to go on payroll and set a reasonable pay rate for yourself and report and pay payroll taxes. Your pay will be deducted as a business expense on the corporate income tax return. Any profit from the sub S corporation above and beyond all ordinary and necessary business expenses, (including your W2 wages), will not be taxed at the corporate level. Instead, the profit (or loss) will flow out to you and any other shareholders on a Schedule K-1 where it will be included as passive income on your form 1040.
The advantage here is that passive income is not subject to the 15.3% self-employment tax which funds your Social Security and Medicare accounts. Sole proprietors and partners in a partnership are required to pay this tax on profits. Also, as passive income, sub S income can offset passive losses. This means that if you are in a high-income bracket, and have losses on rental real estate for example, you can apply those losses to your sub S income.
If you were a sole proprietor or a partner, those rental real estate losses may very well be suspended and carried forward to future years because your income levels are too high and your business profits aren’t classified as passive income. For example: You own three rental properties that report a loss on Schedule E of $50,000 and your sub S income on your K-1 is $200,000. You can apply the rental losses to the sub S income and pay taxes on only $150,000. If you instead were a sole proprietor, you would be required to pay taxes on $200,000 and carry forward $50,000 of passive rental real estate losses to future years. Ouch!
Your wheels are turning. You are considering becoming a sub S corporation, giving yourself a salary of $30,000 on which you will essentially pay the 15.3% self-employment tax although it will be called payroll taxes at that level. Then you’ll take the remainder of your profit; let’s say $200,000 as passive income, free of that big tax hit. Beware! Several years ago the IRS landed on all fours on attorneys doing just that. The project consisted of reclassifying the passive income as wages and hitting them with expensive payroll tax bills along with penalties and interest. Its point being that the wages taken were not reasonable in light of the profit. After all, how many attorneys would go to work for a profitable corporation at a salary of $30,000 per year?
Another caveat: It may not be prudent to go to the expense as well as the increased paperwork requirements of incorporating if your profit is less than $100,000 per year or if you are the type that refuses to keep up with paperwork. Failure to comply with the complex rules and paperwork requirements of corporate life may well blow your corporate structure and the legal shelters it provides right out of the water. That’s why I admonish you to visit both an attorney and a tax pro before diving in.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.