How One Client Saved $24k on Their Taxes by Becoming an S Corporation

As an entrepreneur, you have the opportunity to structure your business in a way that makes the most sense for you. But with so many options available, it can be difficult to know which one is right for your specific situation. Should you be an LLC, a sole proprietorship, or an S Corporation? 

Well, it depends on your situation and in this episode I'll break it all down for you.
I'll walk you through the math and give you a worksheet to help you see if S Corporation is right for your business. 

So if you're looking to cut down on your tax bill or just want to improve your overall tax strategy, you're in the right place. Hit that play button, and let's dive right in!

IN TODAY’S EPISODE, I DISCUSS: 

• The different types of business entities
• Importance of having a good tax strategy for your business
• The best time to switch to an S Corporation

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• Your Business Is a Bad Wealth Plan
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• Should You Convert Your IRA to a Roth IRA?
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Transcript

Mel Abraham  0:00  
Why would you want to be an S corp? Well, in this episode the Affluent Entrepreneur Show, I'm going to answer that question. Now it doesn't fit for everyone, but it's one of the most often asked questions I get. Should I be an LLC? Should I be a sole proprietorship? Or should I be an S corp? Well, stay tuned, because in this episode, we're going to walk through, let's see in the episode, cheers. This is the Affluent Entrepreneur Show for entrepreneurs that want to operate at a high level and achieve financial liberation. I'm your host, Mel Abraham, and I'll be sharing with you what it takes to create success beyond well, so you can have a richer, more fulfilling lifestyle. In this show, you'll learn how business and money intersect. So you can scale your business, scale your money, and scale your life, while creating a deeper impact and living with complete freedom. Because that's what it really means to be an  affluent  entrepreneur.

Mel Abraham  0:58  
All right, welcome to this episode of the affluent entrepreneur show this one, we're gonna talk about a question that I get often, and that is, when should I convert to an S corp? Why should I be an S corp. But before we get there, let's just talk about what they are going to talk about the different entities and all that stuff. As a business owner, as an entrepreneur, we have the opportunity to be whatever we want to be. But let's look at this, I'm going to jump to the iPad, because I'm going to walk you through how we get taxed. In fact, there's two tax systems that that that we have in in the US, and that is a tax system. That is for the wage earner the employee. And then there's a tax system that is for the business owner, the entrepreneur, they're part of the same tax code, but the difference is the way that we take our deductions and how it applies to us. And anyone that has a business has the ability to do this. So I'm gonna jump to my iPad so we can see this, but let's just look at money comes in the door, as an employee that comes in the door as wages, okay, salary as a paycheck, as, as an entrepreneur that comes in is what we call revenue. Okay. And as revenue, now we, we can then put income against it, okay. And so what happens as an employee, though, is that as an employee, we pay taxes, when you look at a paycheck, if you've ever been an employee, you get paid $1,000. But the paycheck the net Check, I remember, I remember, early on when I didn't understand this. But I thought I was getting paid back then back then it was a big deal. I was getting paid five bucks an hour. So five bucks an hour, I worked 20 hours that week, I thought I was gonna get, you know, 100 bucks. Okay. But when I got the check, he was like, $55, I'm going well, wait, I'm getting paid for how, how is it that I didn't get the full $100? Well, it's because as an employee as a paycheck as a wage earner, they take the taxes out. First, the government wants their money first. Okay. So as an employee, you get your paycheck paycheck, but you pay taxes from that paycheck. And then from that paycheck, whatever you have is the net pay is what's used to pay your bills. It's what's used to build the legacy and the life that you want. But now let's look at the business because this is important. The money that comes in for the business is called revenue, okay? It's called revenue. Be called sales, but it's called revenues. Okay? The business that has expenses, they have to pay for office rent, they got to pay for supplies, they have to pay for utilities and phones and stuff, and wages and everything. So they have expenses. And so they pay business expenses. Then, once they have the business expenses, that gives them a net, okay, so I have $1,000 in revenue, I have $200 in expenses, that means my net is $800. And then depending on the kind of entity they are, they will then pay taxes. Now notice something here. When you look at this chart, you'll see that the employee pays their taxes and then pays their bills. But the business pays some expenses, then pays their taxes. It's a little different. And then what's left in the business gets distributed out to the owners and it can be distributed in a couple of different ways. One, if it's a pass through, which we'll talk about which is an S corporation or an LLC, then the income gets passed through that way. You can also take a salary from your own company. Now you don't do it in sole proprietorship, or LLC, but in a corporation you do. So you can take a salary a paycheck just like an employee, or it comes out as dividends. Or it comes out as distributions in a pass through entity. So then from there, there are three of these that you pay taxes on dividends, wages, and the pass through the distributions you don't pay taxes on. So it's a very different system, because what ends up happening is that you see, what happens is that we've paid a lot of bills before we pay our taxes, and then we pay taxes to pay our bills, which then allows us to live the life we want. So bottom line is this, let me summarize it for you. Because this can get complicated. As an employee, you pay your taxes first, and you pay your bills with whatever is leftover as a business, you pay your business expenses first, then you pay taxes on what's left over, and then you pay your bills. Now some of those things that are business expenses also benefits your personal life and therein lies the possibility of having to tax systems to make a difference. Okay, so hopefully that makes makes sense to you. And so, let's talk about the different entities and then let's talk about S corporations in general, okay. When we look at the different ways you can do business, it comes in in a variety of forms, when you first start out most people will start as a sole proprietorship, that is you do a de DBA doing business as and it it is a sole proprietorship, it shows up on your personal tax return on what we call a Schedule C. form, okay? When you are a sole proprietor, you pay two kinds of tax, you pay something called self employment tax, okay, and you pay something called income tax, self employment tax, self employment tax is the business version of Social Security. When it's not the way they define it, it's the way I see it, okay. Because as a an employee, you pay Social Security tax out of your paycheck and the company pays a portion for you. But as a business owner, and as a sole proprietor, you don't have Social Security tax, so they charge you self employment tax on your net income. So you are actually paying in the system and that is actually at 15.3%. So it's a big number. The second way that you can be formed is what we call a single member LLC, which is what most people do but single member LLCs get the same tax treatment. As a sole proprietor it shows up on their schedule C, and they're subject to self employment tax, and income tax. Okay. Single Member LLC means that you are the only member your spouse isn't a member, you're you don't have partners. It's a single member LLC. Okay, so the LLC and a sole proprietorship do not pay taxes directly, you pay them personally on your tax return, and you're subject to taxes, self employment tax and income tax. Okay. Now, let's look at something else. Let's look at the next type of entity. The next type of entity is a corporation. Now, when you create a corporation, this is a legal entity. Separate from you, separate from you, it files a form 1120, which is a different tax return. So you'll file a separate tax return for the corporation. This is a regular corporation, not an S corporation. And that corporation will pay taxes. If you take money out of the corporation as wages or dividends, then you'll pay taxes again. In other words, you will pay taxes twice. If you're a regular corporation. That's why small businesses in many cases do not become corporations because you're gonna pay taxes at the corporate level, and you're gonna pay taxes personally, and we don't want to pay taxes on the same income twice. All right, but you're subject to corporate income tax if we are corporate ration and that corporate income tax depends is changing but is 21%. It depends on the state and that type of thing. Now, let's look at the LLC again, because the first LLC we looked at was a single member LLC, which got treated just like a sole proprietorship, but a multi member LLC, meaning that there's more than one member that own the LLC is treated like a partnership. And as a partnership, you form a use file a separate form, just like a corporation. It's a different form, it's a form 1065.

Mel Abraham  10:36  
But your income that the LLC typically doesn't pay any taxes none. Unlike the corporation, the corporation pays its own tax. The multi member LLC doesn't typically pay taxes, although if you're in California, you're a lucky one, you get to pay a tax. Okay, but multi member LLC Sep file a separate form, they don't pay taxes, but the income that comes from that, that LLC passes through and ends up on your personal tax return. And this is where you, again, are subject to self employment tax. Okay, now 100% of the income coming from the LLC, either as a single member LLC or a multi member LLC, is subject to self employment tax and income tax and possibly state tax. Okay, so, so a multi member LLC will pay the 15.3% plus any income taxes. That leads me down to the S Corp. And then we'll walk through some calculations. The S corporation is is a corporation. It is the same type of corporation that we did here, it's a C corporation, and all you're doing is making an election with the Internal Revenue Service, you are filing a Form 2553 that says to them, I want to be treated like an S corp, meaning that it is a pass through corporation, you will still file a separate tax return, it's called an 1120 S, okay. But all the income passes through to you all the income passes through to you like before, the difference between an S corp and an LLC, is the S corp has no self employment tax, you avoid the 15%. Okay, kind of. Okay. So you're going to pass through the income from the S Corp. However, the here's the difference. And this is the important part. When you convert from an LLC or a sole proprietorship to an S corp, you now have to pay yourself a salary as an s as a sole proprietorship and LLC, you don't pay a salary. So now all of a sudden you get a paycheck. But here, you'll start to see the calculations because on that paycheck, you'll have to pay Social Security tax. But let's walk through some calculations. So you can see the benefits of and this is why a lot of people they get confused and they don't want to do it and and I'm throwing a lot of data at you. But this is really important to understand because I had a client that their CPA did not want to make the election to be an S corp. And I went through and I said let's do the analysis that I'm going to show you the analysis literally saved them $20,000 in tax by turning themselves into an S corp. Do you think that the hassle the headache, the expense to convert to an S corp, which isn't really a lot of hassle, a headache or expense was beneficial? Yeah. Yeah, because they saved 20 grand and tax. Let's look at how this plays out. Let's walk through some calculations okay. As an S corp or as a as a sole proprietor, let's just look at the sole proprietorship first. Okay, the sole proprietorship, let's say that you have $250,000 in revenue, okay, this is this is the income that comes in, but you have expenses let's call it 50,000 expenses, okay. That gives you a net of 200,000. Now mind you the net because it is a sole proprietor or a single member LLC, it ends up on the schedule C 100% of the net has to pay self employment tax on that on that money. Okay, and there's some limitations but but the self employment tax on this at at the 15% would be approximately $28,000 You And then they pay income tax. Now, I'm assuming a rate of 20% here, but they pay income tax on the 200,000. On top of that, so that's $40,000. So effectively, this LLC, or s, or, or a sole proprietor is going to pay $68,000 in taxes. Now, there may be some reductions in the self employment tax because of limitations and everything. But I'm just trying to do some very, very fundamental math for you to see the differences. Well, what happens if you were an S corp? Well, two things have to happen when you're an S corp. One, you're you have to pay yourself a salary, which is market rates a salary, and two, and that salary is gonna be subject to Social Security tax, and then to you're not subject to the self employment tax. So this, this can go away. So let's just look at what it looks like when we say we're an S corp, same to earn 50,000, another 50,000, and expenses just like before, but remember, we say we have to pay ourselves a salary. So in this case, they're going to pay a salary of $60,000. That's $60,000, you're gonna have to pay Social Security tax on Social Security tax on the paycheck side on the employee side is, is basically 7.45%. But the company also has to pay 7.45%. Also, okay, so, on your paycheck, you're going to pay $4,500. And then the company is going to pay $4,500. Okay. All told, you're going to pay about $9,600 in tax on the paycheck, remember, and this is Social Security versus self employment, the self employment tax was 28,000, the Social Security tax is 9600. Because we did a salary instead of the full pass through, but now you still have the income tax you got to pay, and the income taxes paid on the net. Now the net is a little less because we take a deduction for the payroll taxes. So our income tax goes down from 40,000 to 39,000. But here's the thing, the tax savings between being a sole proprietor or LLC and an S Corp is almost $20,000. When we do this now, people will say, well, that's great. But when do I do this, here's the thing. We look at it. Now, I'm not giving you recommendations here, because I don't know your specific set of circumstances. But in general, the time to start looking at whether you should be considering going into an S Corp is when your net income is exceeds 50 or 60,000 hours, it's the time to look at it, it doesn't mean you automatically do it, you do the analysis, you take a look at it, and you make the decision, because here's how that works is that if all of a sudden you're making $200,000 and you can take a salary of 60 the difference, you're gonna not pay self employment tax, and you're gonna save money now, is there an expense to it? Sure there is you got to follow the election forms, which is a form 2553 It needs to be filed within 75 days of the year end or the formation of the entity. If you don't do it, then then you have to ask for a special election, which will take a little more effort, which may mean that cost more, you'll have to adjust your payroll and do some things to make sure that you you do it right. But you can get a an S election in place, you could literally do it now for last year. If you if you qualify, okay, and take the benefits of it. I like I said I had a client that we went back and we did it. And they it saved them over $20,000 in taxes by doing it correctly. The challenge is too often we don't know or or accountants and CPAs. And taxpayers aren't really looking at it from that perspective. So here's what I want you to do. I want you to look at this and say wait a second, if my net income, income minus expenses is more than 50, or $60,000, I want you to have a conversation with your accountant with your tax preparer with someone to see if it makes sense to start to consider going to an S corporation because they can, it can save you a fair amount of money. Let's just look at something I'm gonna walk through a calculation. I'm going to show you the worksheet that I use. I'm gonna just drop jump to this. So this is the worksheet that I use. You'll see that it doesn't make sense when the incomes down I have the income at 20 250,000 If I take that income down to 100,000 Okay, it doesn't really make sense. And I got to take the salary down to 40,000. Because otherwise I end up in a loss, you'll see that the savings isn't a lot. It's $1,200. Okay, so. So it doesn't make sense until your net income is well above the $50,000 level. But it does make sense. This is the analysis that I'm showing you here, that your accountant or tax preparer needs to go through to see if it makes sense. But the bottom line is this.

Mel Abraham  20:33  
There's a reason and a time to use the S corp to reduce your taxes and put more in your pocket. It's not at the outset. It is somewhere down the road when you're starting to make money. And you can start to reduce the impact of self employment taxes, Social Security. So that's, that's the answer. It's not hard and fast rule. It is circumstance by circumstance. And you need to do an analysis to make that happen. But this is the question that I get, more often than not, when it comes down to these should I be an S corp or being an LLC? And the answer is it depends. So I hope that this gives you some guidance. Go back through it. I gave through a lot of information at you, I did some calculations. If you're listening to this, go to the YouTube channel and watch it so you can see it, slow it down, go through it, make sure you understand it and then talk to your advisors talk to your tax preparer. Because if if you're like my client, it could save you over $20,000 Depending on your situation. I hope that this helps. Alright, until we get a chance to see each other another episode of the affluent Entrepreneur Show. Always, always strive to live a life that outlives you. Thank you for listening to the Affluent Entrepreneur Show with me your host Mel Abraham. If you want to achieve financial liberation to create an affluent lifestyle, join me in the Affluent Entrepreneur Facebook group now by going to melabraham.com/group and I'll see you there.