The other day, one of my sons was walking around the house in my shoes.  When I noticed this, I playfully began chasing him around.  He stumbled a bit and was noticeably slowed down because the shoes didn’t fit him.  Once he kicked my shoes off, he was much more efficient in running and getting away from me.

Using the above story as an analog — I meet with a lot of business owners that want to be taxed as an S-Corp without knowing much about what that means.  Oftentimes, they get advice from their neighbor or a friend with good intentions but not necessarily all the information.  The point I try to emphasize with them is that there is no “one-size-fits-all” way to set up a business.  Let me illustrate with an example:

Facts for this example:

• Lorette has set up an LLC for her new business and she is the only owner.
• A reasonable compensation for her industry is $40,000.
• Her filing status is single.
• For Scenario A – Her business’s taxable income before her compensation is $100,000.
• For Scenario B – Her business’s taxable income before her compensation is $50,000.

In this situation, the most common options for her would be to be taxed as a Sole-Proprietor (Form 1040 Schedule C) or to be taxed as an S-Corp (Form 1120S).  If she were to do that, this is how the numbers would fall (click on the image to make it bigger):

I don’t necessarily want to break down those numbers too much for this article other than to point out that in Scenario A she would save over $5,600 tax dollars by being taxed as an S-Corp.  However, she would have additional accounting fees to file an S-Corp tax return and to run payroll and file quarterly and annual payroll tax reports.  Even with those accounting fees factored in — she would come out ahead by filing as an S-Corp.

However, in Scenario B, she has a tax savings of $12 by being taxed as a Sole-Proprietorship rather than being taxed as an S-Corp.  That isn’t much savings, but she also avoids having to pay additional accounting fees as she wouldn’t have to file a separate business tax return or file any payroll reports.  She could “stumble around” as an S-Corp, but in this scenario, she would be better off to be taxed as a Sole-Proprietorship.

So, as you can see — there is no “one-size-fits-all” setup for a business.  The advice to set up your business with an S-Corp tax election may be good advice but it isn’t always good advice. My goal with my clients is to help them operate at a level where they can run efficiently and save the most money on their taxes as legally possible.

If you are looking at starting a business and want to talk about your options for entity structure, or if you own a business and want to see if you are operating under the correct structure I would love to have you come in and meet with me or one of our other CPAs and discuss your business.

* Estimate based on 2020 tax rates and filing status.  Example for illustrative purposes only.  Please consult with a HintonBurdick professional regarding your personal situation and circumstances.

** SE tax is paid on the 1040 of a Sole-Prop, or through payroll as an S-Corp.