The 2018 tax season is here! We are finally going to see the effects of the tax law change at the end of 2017. And as you can image, lots of questions are coming in already.
One subject that has really caught my eye has been how to handle running an S-Corp as a sole shareholder. You’ve likely heard a lot of talk about the new 20% Qualified Business Income (QBI) Deduction. Many businesses are now reevaluating their business structure to see what is best. This is especially important for those running a business by themselves.
For instance, one of my small business owner clients recently asked me whether it made sense for her to reorganize a single member LLC into a solo S-Corporation because of the new law. It’s a technical question, and it has broad implications. Today, I want to talk specifically about running an S-Corp as a one-person shop and what you should consider if choosing this structure.
What is an S-Corp anyway?
The simplest form of business organization for a one-person shop is a sole proprietorship, where you and your company are essentially the same entity. That works up to a point. But what if your business gets sued? You could lose your house, your personal savings, college accounts for your kids, even your car. If you want to shelter personal assets from legal liabilities, you have a choice between two types of business structures.
Single Member LLC
To avoid the unlimited liability of a sole proprietorship, you can organize your business as a single member LLC (Limited Liability Company). LLCs are straightforward to administer, and in most cases, you’ll still report income on a Schedule C. However, you gain some protection because your business is considered a separate entity.
In an LLC, you are only liable for damages up to the amount that you have invested in the business. However, you should make sure to keep your personal and business assets separate to prevent creditors from “piercing the corporate veil.” Simply put, that means a creditor can sue for your personal assets because your business and personal assets are comingled and your LLC only serves as a shell for a separation that doesn’t actually exist.
You also have to take a few more steps to set up a LLC than you do for a sole proprietorship. You have to file articles or organization with your state, and you should have some sort of operation agreement that explains how the business will carry out its mission.
One last potential pitfall of the LLC is that you have to pay self-employment tax on all business profits because, for tax purpose, you and the business are one in the same. The self-employment tax rate is 15.3%, which consists of 12.4% in for social security and 2.9% for Medicare. You may remember these amounts that were withheld from your pay stubs when you were an employee.
S-Corporation
An S corporation separates you from your company completely, for both operational and tax purposes. The business is its own entity, and you as the owner are the sole shareholder and an employee. That division, however, comes with operational costs.
To create an S corporation, you have to file articles of incorporation with the state, appoint officers and create bylaws for the business. In addition, you have to adhere to corporate formalities including paying yourself on payroll, meetings of the board of directors and taking meeting minutes (even if you’re the only one in the meeting!). Lastly, you to the file a Form 1120s for the business and the business profit or loss will flow through to you personally on a Form K-1.
Many one-person businesses find these requirements too time-consuming and expensive. Additionally, some states, like Illinois and New York, have additional taxes on and costs for S-Corps. But you can obtain significant tax savings if your business ends up making a substantial profit.
Why would anyone choose an S-Corp?
Before the TCJA, most of the talk around choosing an S-Corp vs. an LLC revolved around the self-employment tax savings mentioned above. For example, if you were an accountant that made $200,000 in net business income, and gave yourself a “reasonable salary” of $100,000, you’d save $15,300 in tax by having an S-Corp vs. an LLC. That’s a nice chunk of change.
The key issue here is what constitutes a reasonable salary. This issue has long been contested, as people tend to push reasonable limits in order to save in self-employment tax. Business owners have even more incentive now that the QBI deduction only allows a 20% deduction for profits from the business, not salary. (You can read my business owner cheat sheet on QBI here.)
The IRS determines reasonableness on a case-by-case basis but offers ten factors as guidelines. These include your role and duties in the company, your background and experience and amounts paid to others in similar-situated businesses. It’s a grey area, but experts have developed some rules of thumb — for example, the ideal salary is equal to one-third of business income up to the Social Security wage base, or, more recently, the “perfect salary” is 28.57% of your income.
While I love a good rule of thumb, small-business owners who are making the decision between these two entities need to take extra precautions . If your business revenue comes mostly comes from your services, the IRS will likely see all of your business income as your salary. In other words, all of you solo accountants, advisors, etc. need to consider the fact that it may not be reasonable for you to have any dividend income at all. That fact defeats the purpose of having a more costly and burdensome S-Corp.
Here are a few court cases that can shed a bit more light on the subject.
- Spicer Accounting, Inc., Plaintiff-appellant, v. United States of America, Defendant-appellee, 918 F.2d 90 (9th Cir. 1990) Spicer was the president, treasurer and direct of his corporation Spicer Accounting Inc. He was the lone accountant in his firm. He received no compensation for his services but did take distributions (and thus paid $0 in payroll taxes). The district court held that Spicer was an employee and that payments to him were wages. The 9th circuit affirmed the district court’s ruling finding that as the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits and preparing opinion letters. Thus, his services were “integral to the operation of the firm” and all payments to him should be considered wages subject to FICA and FUTA tax.
- Sean McAlary LTD, Inc. v. Commissioner of Internal Revenue, T.C. Summary Opinion 2013-62. McAlary was a real-estate agent. He was the president, secretary, treasurer and sole director and the sole shareholder of his S-Corporation. He managed all aspects of the corporations operations, and was the only one in the firm that held a broker’s license. However, he did supervise eight independent contractor sales agents, four of whom generated sales for him. McAlary paid himself $24,000 per year and took a $240,000 distribution. The IRS determined that $100,000 of the $240,000 as reasonable compensation basing it on the median hourly wage for real estate brokers in California. The Tax Court took an even smaller figure of $83,200 basing it on $40/hour. The key factor here seems to be that while the only shareholder in the S-Corporation, McAlary wasn’t the only one producing income. Thus not all of the distributions were wages.
- Glass Blocks Unlimited v. Commissioner of Internal Revenue, T.C. Summary Opinion 2013-180. Fredrick Blodgett was the president and sole shareholder of his S-Corp that sold and distributed glass blocks. The firm had no other full-time employees and Blodgett was responsible for all operational and financial decisions for the company. Although he did not receive a salary, Blodgett received $30,844 and $31,644 in distributions from the company in 2007 and 2008. The IRS argued that those entire amounts should be considered wages. The Tax Court agreed finding that “any officer who performs more than minor services for a corporation and who receives remuneration in any form for those services is considered an employee, and his or her wages are subject to the employer’s payment of Federal employment taxes.” Blodgett tried to claim that a reasonable salary would have been $15.25/hr for 20 hours a week based on wages for a shipping clerk, an accounts receivable clerk, or an accounts payable clerk. But the Court did not find his argument persuasive, as he performed all of those roles within the company and generated all of the business’ sales and income for those periods.
How to choose
My hope is to equip you with enough knowledge and tools to have an effective conversation with your tax or financial advisor of whether an S-Corp is best for you. In that discussion take into consideration the following questions:
- What type of business do you have? Service businesses trigger both the reasonable salary requirement and the ability to take the QBI deduction.
- How much of the income is derived from your work? Check out the IRS ten-factor reasonable salary test.
- Are you able to follow corporate formalities like meetings and payroll? You can hire someone to help with this.
- How much of your net business income is above or below the social security wage base ($132,900 for 2019)? The more above the wage base, the more appealing the 20% QBI deduction.
- Which retirement vehicles are you using? A single-member LLC allows you to save faster with a Solo 401k.
Also, keep in mind that you don’t have to choose right away. As a single member LLC, you can elect to be taxed as an S-Corp as long as the election is made no more than two months and 15 days after the beginning of the tax year you want the election to go into effect. You make the election on form 2553. You can also withdrawal that election by writing a letter to the IRS regarding your intentions.
One final word of caution: do not make these decisions in a vacuum. The savings in self-employment tax and QBI deduction will have to be balanced against one another. Additionally, a change in entity type can have long-lasting implications. We don’t know if the QBI deduction will be around after 2025. So talk to your tax and financial advisor to see how these provisions will affect you.