You've probably heard that an S-Corp could save you a bunch of money on taxes. But boy are S-Corp complex and confusing. The key to understanding if an S-Corp is right for you - or properly maintaining your S-Corp if you already have one - is understanding the one (fairly) simple way the S-Corp election works. And that's what I'll cover in this week's video.
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Maybe you’re considering the S-Corp election. Or maybe you’ve already made the election. Either way, it’s really important for you to understand how it's actually working. Too often, I've seen people jump into the S-Corp election without understanding the gravity of some of the decisions they're making. I don't want that to happen to you. You need to understand the way your S-Corp is working so you can make thoughtful decisions that don't later get you in hot water with the IRS.
So let's jump into it.
Three Different Types of Tax to Manage
The key to the S-Corp tax savings comes from the fact that different types of income get hit with different taxes. So let's walk through the three different kinds of taxable earnings that you might receive.
- General Income. The IRS (and in many cases your state government) generally taxes you on all income from any source. All of your income (with a very few limited exceptions) will be subject to Federal and State Income Tax.
- Earned Income. Earned income is income you receive in exchange for working a job. Earned income gets hit with regular income tax and ALSO gets hit with FICA tax. FICA tax is synonymous with Self-Employment tax and is up to a whopping 15.3% making it a painful tax to bear.
- Payroll Income. Finally, we have income from payroll. Payroll means income you receive from a formal paycheck. Payroll earnings have a rough go of it - they get hit with all the taxes. It's income so it gets hit with income tax. It's earned income so it gets hit with FICA tax. And it's payroll so it gets hit with payroll taxes. Ouch!
If this is confusing, go back and watch my video on understanding taxes in your private practice. There is a link in the description box below.
Default Taxation of your Private Practice Earnings
Let's say you're operating your therapy practice as a Sole Prop today. What kind of earnings are you making from your business? They're all in that middle, Earned Income, category. You're getting hit with income tax AND FICA (aka Self-Employment) tax. But at least you're not getting hit with payroll tax!
If you operate your practice through an LLC, in most cases, the default way you're taxed is just like a sole prop. In general, simply forming an LLC won't change your taxes one bit.
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The S-Corp Election Changes How You're Taxed
If you make the S-Corp election, the nature of your earnings changes. And it is this change that creates the potential for tax savings. That change is that your earnings get split into two different parts. This splitting of your earnings into two parts in the only way the S-Corp saves on taxes. This is the entire secret to S-Corps.
Let's look at the two different buckets an S-Corp splits your earnings into.
- Profit Distribution. For one part of your earnings, we're going to move it out of the Earned Income bucket and into the General Income bucket. That means you avoid that FICA, or Self-Employment, tax and that can be a big tax savings. This is the profit distribution from your S-Corp and you earn that profit because you are the owner of the S-Corp.
- Payroll. For the other part of your earnings, we're going to move it from the Earned Income to the Payroll category. So guess what? That part is actually going to get hit with MORE taxes! This portion of your earnings is compensation for working in your business. You get this part of your compensation not because you're the owner of your business but rather because you're an employee working IN your business.
Setting Reasonable Compensation is One Critical Decision You Need to Make
As you've probably already figured out, the more of your earnings that you can push into the profit distribution part of your overall compensation, the more you'll save on taxes. That's because remember that profit distribution avoids both the FICA tax and payroll taxes. Profit distributions only get hit with income taxes.
And you make your profit distribution as large as possible by setting your salary as small as possible. That salary, or paycheck, you take from the business will get hit with all the tax - income, FICA and payroll taxes. So of course we want to make that as small as possible.
But guess what? The IRS is wise to this strategy! They don't want you to set your salary super low so you avoid tons of taxes. Therefore, the IRS requires that you set your salary at a reasonable level. This is known as the Reasonable Compensation standard.
Setting salary exceedingly low is where I see people sometimes get into trouble.
I've seen some S-Corp owners set their salary set really, really low. In some cases, the business owner is taking just a few thousand dollars each year in salary and receiving ten of thousands (if not over $100,000!) of dollars in profit distributions. This is a pretty aggressive tax move. Maybe you never get audited by IRS, but if you do this strategy could land you in a heap of trouble including back taxes and penalties. This is not something I want to happen to you.
What's the solution? Have a thought-through and documented rationale as to why you set your salary at the level you did. If the IRS questions your salary and you tell them "It's just what my CPA told me to do"... the IRS is unlikely to find this argument compelling.
There are a ton of different ways to to approach setting reasonable compensation. You should work closely with you tax professional in making this determination. Some data points that might form the basis of your thought process for establishing your reasonable compensation include:
- How much do therapists generally earn in your area? The U.S. Bureau of Labor Statistics complies data on this.
- How much would you pay an employee therapist in your practice? Perhaps that's 50% of their billable rate.
But wait, there's more!
If you can get comfortable with setting your reasonable compensation at a level where you can save a lot on taxes, the S-Corp election could be a great move for you. But it is complicated and somewhat irrevocable, so you want to consider it carefully.
If you think the S-Corp strategy can you money in taxes, that's step one. There is a lot of work to do, complexity to navigate and additional expenses to be incurred when forming an S-Corp.
I'll cover all of that in next week's post, so be sure to check back and also be sure to subscribe if you haven't already done so!
That's a Wrap 🎬
That's it for this week's post! I hope you found it helpful and maybe even inspiring. And please let me know what you think! What made sense, and what points were confusing? What else would you like to hear about? Give me a shout and lemme know!
And if this all feels a bit much to navigate on your own, give me a shout! I work one-on-one with therapists from all over the country. There are a three different ways to work with me, all of which I describe on my services page. One is sure to meet your needs and fit your budget!
Turning Point is a registered investment advisor in the state of California. Please visit turningpointhq.com for important information and additional disclosures. This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes financial, legal or tax advice; a recommendation for purchase or sale of any security; or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Read the full Disclaimer here.