If you work in the freelance or self-employed arena at all, you have probably heard of S-Corps, but I have never actually sat down and written out what an S-Corp is and why you need one. So here’s the quick version.
Disclaimer: This is a QUICK version. Almost every statement I make in here has some exceptions. It’s the Tax Code; it’s a mess. I am giving you a broad view and trying to create something useful for people, NOT teach you a class on entity taxation. Please use this as a guide and do not rely on this as a substitute for tax advice.
If you perform work as an independent contractor, whoever hires you is supposed to give you a 1099 telling the IRS how much they paid you. You report that income on Schedule C of your personal tax return as your gross receipts or gross income. Hopefully, you are smart enough to deduct from that income some expenses. Things like business use of home, auto miles, cell phones, etc., all those things you have heard about. After you complete the form, you end up with profit. You pay two kinds of tax on that profit: income tax and self-employment (SE) tax. Income tax is what you are thinking about when you typically think of taxes. But as a self-employed person you also pay SE tax. This is effectively both halves of the Social Security and Medicare taxes, which normally runs around 15%, but people that have W–2s only pay half because their employer pays the other half. If you do not have an employer, you are in fact your employer, so you pay the tax twice. Yes, it’s a lousy deal. I know. You want to decide you want to try this S-Corp thing.
Wait, what, exactly, is an S-Corp?
An S-Corp is a business entity (either LLC or C-Corporation) that has elected (under Sub-Chapter S- of the Internal Revenue Code, hence the name) to be taxed as a pass-through. “Whoa, that was a lot of words that I don’t understand!” you say. It’s cool. It’s not as complex as it sounds.
Legally, there are two (main) types of entities: Corporations and Limited Liability Companies. You need a lawyer to explain the difference, but suffice it to say that, legally, you have to have one of these to create a legal entity that is distinct from you personally. Corporations (referred to as C-Corporations) pay their own tax. This is where you hear about the double taxation problem. The company pays tax, then when you get the money out, you pay tax again. Yuck. We only use these in special cases. But at least you don’t pay SE tax on the money! An LLC can file as either a Corporation or a Partnership. Filing as a partnership means that it doesn’t pay its own tax, it “passes through” the income to the partners, who pay their own tax. This is the same as being self employed, so whatever you get from an LLC you also pay SE tax. The only difference between this and a Schedule C is liability protection.
But what if we took the C-Corporation “no SE tax” thing and combined it with the “no double taxation” of the LLC? That would be pretty neat. We call it an S-Corp, and it is neat. An S-Corporation is a tax election that says, “I am a corporation electing to be taxed as a partnership.” For the record, either legal entity (Corporation or LLC) can be an S-Corp.
Corporation or LLC? – legal question, nothing to do with tax
Pass Through or Corporation? – tax question, nothing to do with legal issues
Back to your own journey!
The main purpose of S-Corps is to manage this SE tax. Let’s go back in time. You work for a person or company, and they pay you as an independent contractor. But this time, instead of you receiving the money personally, you have it paid to your employer, You Inc. You don’t receive a 1099. You report that income on an 1120S. It is, for our purposes, the same as a Schedule C. You report the gross income. You deduct from it expenses like office rent, auto expenses, cell phones (sound familiar?) and arrive at your profit. That profit “passes through” to your personal return. You pay income tax on this number. You pay no SE tax on this number.
Simple, right? Same system, but running it through an S-Corp you avoid the SE tax. Now, let’s make it a little tougher.
You do have costs with an S-Corp. Most states charge a flat fee for it (in CA it is around $800), plus you have to pay to set it up and pay someone to do the second tax return you need. So do a cost-benefit analysis on this.
It IS more complex—keeping more money always is—you have to have books and another account for your company. It is a separate legal entity; you cannot use your own bank account or the IRS will get REALLY touchy.
You do HAVE to pay some SE tax. But this is OK because we still want to qualify for Medicare and Social Security when we retire. This just allows us to manage the amount.
The S-Corp generally has a MUCH lower audit risk than a full blown Schedule C. Which means you can typically deduct more things, saving Income Tax in addition to SE Tax.
That about sums it up. Yes, this is the short version. Give me a shout if you think this is for you!