With April quickly approaching, you might be in the midst of your 2022 taxes, figuring out what you owe or what the Internal Revenue Service (IRS) owes you. But for operators of limited liability corporations (LLCs), there’s a deadline that’s worth noting, if they want to reduce the stress of the 2023 tax season.
One of the most popular designations for the self-employed is the sole proprietorship. It makes sense, since as people decide to work for themselves, they must figure out if the lifestyle and business will prove profitable. With no real paperwork required for a sole proprietorship, it’s the one that new owners fall into. But as the self-employed person or small business matures, they often shift to an LLC. This gives the business some credibility, as well as a limited amount of liability protection.
For those operating an LLC, however, there’s an important tax move that can significantly reduce their potential tax burden. By opting into an S-Corporation, the LLC can utilize the tax design of an S-Corp, while not having to deal with the hurdles of running a corporation. It creates a tax advantage that’s unmatched by even those working as full-time employees.
This deadline to opt-into an S-Corp for the 2023 tax season, for most filers, will hit on March 15.
What do you gain by opting into the S-Corp?
As an independent worker, you pay taxes on regular income, just like a W-2 employee. But, whether you have a sole proprietorship (which is how the IRS views you if you have not signed up for a business designation) or LLC, then you also have to pay the self-employment tax. This tax covers Social Security and Medicare.
Employees that work in-house also pay this tax. But they have an employer that ponies up half of the 15.3% tax (for most employees). Being self-employed, you’re both the employer and the employee, so the only person to pay half of the 15.3% tax is you. While you’re able to write-off half of the tax, it’s not the same as not paying it.
But there’s a way to reduce the amount you pay in self-employment taxes and that’s through the S-Corp design.
How does the S-Corp Opt-in work?
Under an LLC, everything you make passes onto you. Instead of a salary, any money that comes in, you’re taxed on the amount.
In the S-Corp design, you’re now an employee of the company, as well as the owner of the business. This has a dramatic difference in what and how you pay yourself.
First, you can set a salary for yourself, based on the industry you work in. This salary is what you get for working for the S-Corp. Just like the LLC, all of these funds are taxed for Social Security and Medicare.
But, unlike an LLC, you do not have to pay yourself a salary that’s 100% of your yearly revenues. Instead, the IRS says it has to be “reasonable.” If you make more than what’s reasonable, then you only pay yourself that salary.
As for the other part of the revenues, then you can distribute them to you as owner of the business. This essentially works like a dividend, instead of salary. You do not have to pay self-employment taxes on these funds.
This allows you to cut 15.3% of taxes on a portion of your yearly revenues that you have designated as dividend income from the business.
In order to accomplish this though, while operating as an LLC, is to file a specific form for the S-Corp opt-in with the IRS. This has to be filed by March 15, in most cases.
Can any business do this?
To make this work, you have to pass certain requirements. First, you have to be a domestic company and can’t have more than 100 shareholders in the business. For most solo or small businesses in the US, this isn’t an issue.
If you do have any shareholders, they cannot be from a partnership, corporation or non-US resident. And you can only have one class of stock – or, in other words, you cannot have stock that gives you more voting rights than other shareholders.
Outside of those stipulations, certain C-corps, like some financial institutions, insurance companies or domestic international sales organizations cannot use this opt-in.
Now, whether or not you want to do this will depend on what you do, which state you live and how much you make. For instance, if you do not make much in the LLC, then there’s little need for the S-Corp since your income will not pass the likely amount that the IRS might consider as reasonable for a salary in your field.
Another thing to consider is if your state adds any significant limitations or requirements for the S-Corp., even when opting into the design from an LLC. If it’s an onerous process, then the reward may not prove as fruitful.
Either way, it’s important to consider these issues now since your deadline to opt-in is only a couple weeks away.