By Andrew D. Schwartz, CPA
To read Part 1 of this series, click here.
In my previous article, we covered the basics of the most popular entity selections. Let’s dig deeper into the benefits and pitfalls of S-Corps. Remember: S-Corporations have the requirement of filing a separate tax return each year and are separate legal entities.
Benefits of S-Corporations
When your practice is set up as a sole proprietorship or LLC, you pay Social Security and Medicare taxes on 100 percent of the income that you report on your tax return. By setting up your practice as an S-Corp, you have the option of taking a portion of the profits as an “S-Corp Distribution” instead of as salary. By doing so, you avoid paying these two taxes. Currently, the maximum combined tax rate for these two taxes is 13.3%. Take a salary of more than $110,100 (in 2012), and the rate drops to 2.9%.
Keep in mind that the rules require that you pay yourself no less than a “reasonable salary” and then only take the excess income as S-Corp distributions. Have the S-Corp issue you a distribution of $50k instead of a paycheck and you’ll save from between $1,450 and $6,650 in Social Security and Medicare taxes, depending on your total annual salary from the practice and other sources.
Pitfalls of an S-Corporation
There are some pitfalls with S-Corps to consider. For starters, expect to pay higher accounting fees since the S-Corp needs to file its own tax return each year. You should also look into the minimum tax that an S-Corp will need to pay in your home state as well as any other states where you operate your practice.
When it comes to deducting certain types of expenses, staying away from the S-Corp might be prudent. It’s actually easier for people who operate their practice as a Sole Proprietor or LLC to claim the home office deduction or to deduct their automobile expenses.
If there are multiple owners to the practice, maintaining a LLC allows the owners to claim any professional expenses not run through the practice directly against their share of the practice income. For practices set up as an S-Corp, each owner would need to claim these expenses as a miscellaneous itemized deduction, which are only allowable to the extent they exceed 2% of each owner’s income and then are capped for any owner subject to the Alternative Minimum Tax (AMT).
And you need to be careful if you earn a good salary working outside of your practice, and also own a profitable practice. Since an S-Corp is required to pay its owners a reasonable salary, there is a chance that someone earning more than the FICA max might end up paying extra Social Security taxes if your salary from all sources exceeds $110,100. Yes, you will get back the Social Security taxes withheld from your pay, but you don’t get back the Company match of 6.2%. The cost of this tax could be as high as $6,93 ($110,100 * 6.2%).
In the last part of this series, I’ll discuss deducting losses and other considerations to think of when selecting an entity type.