S corporations are a hot topic for private practice owners that want to use strategic tax planning to avoid the double taxation that other business entities must pay. There can be a lot of benefits to creating an S Corp, but it may not be the right choice for your business.
Your private practice may or may not benefit from an S Corp, so it’s good to fully understand if this is the right choice for you and your business.
What’s an S Corp?
An S corporation is a special type of corporation with a tax structure that allows the business to pass its income and losses to shareholders. It is especially beneficial for small businesses and private practices.
Under the IRS’ classification, you must meet certain requirements to qualify for S corporation status:
- You must be a domestic corporation, which you are if you’re running a PLLC
- Your practice can have no more than 100 shareholders
- You must have only one class of stock
All shareholders must be “allowable,” so they cannot be partnerships, non-resident aliens or corporations
When you want to reduce your small business taxes, an S Corp can be beneficial because taxes are assessed at each shareholder’s tax rate.
Benefits of an S Corp?
S Corporations were created to help drive small business in the United States. Electing to be classified as an S Corp is easy, and it offers many benefits:
- Taxes. The key benefit is that an S Corp can avoid double taxation except if the corporation has passive income or capital gains which cannot avoid taxation.
- Liability. When your business and personal accounts don’t co-mingle, an S Corp will shield shareholders from personal liability. Shareholders cannot have their assets seized by creditors, nor are they personally liable for any business debt.
- Salary and dividends. Both dividends and salary can be paid to shareholders to lower tax bills further because dividends are not subject to self-employment tax.
- Ease of conversion. Converting from a PLLC to an S Corp is an easy process as long as you meet both state and federal requirements.
Of course, there are also some drawbacks, such as more complexity, a few additional expenses (we’ll touch on this below) and strict qualification requirements.
Difference Between PLLC and S Corp
An S Corp and PLLC are both pass-through entities/elections, but an S Corp may reduce your self-employment taxes. A few of the key differences between the two are:
- S corporations are an elected status rather than actual business entity.
- LLCs can have an unlimited number of shareholders, but an S Corp has their member limit capped at 100.
- S Corps can avoid some self-employment taxes, while a PLLC has to pay self-employment tax on all income earned.
- Management structures may be different, with some S Corps opting to have officers and directors that oversee business operations.
- Members of an S Corp cannot be non-US citizens.
The differences between an S Corp and PLLC may seem small and insignificant, but they can save your private practice a lot of money if you meet certain income thresholds and other criteria.
When an S Corp Makes Sense for a Private Practice
You should be a PLLC because you’re already a private practice*, but if you’re not for some reason or are simply thinking of starting a practice, a PLLC makes it easier to elect to be an S corp.
A PLLC provides an additional layer of protection as an owner, but you also want to do everything you can to keep your business and personal expenses separate. For example, your business should have its own bank account.
There’s a certain revenue threshold when it usually makes sense to elect to be an S corp. If your main goal as an S Corp is to save money, and if you would save money by staying a PLLC, then it’s simply not time to go the S Corp route.
A few of the key times when it makes sense to elect to become an S corporation are:
- Savings. You want to keep money in your pocket, but if you’re only saving $1,000 in taxes, you’re not really saving money. S corporations have additional fees and expenses that need to be considered to make them worthwhile. Costs can include payroll, additional tax returns and so on.
- Gross Income. The amount of gross income where it makes sense to elect an S corp is going to vary from one business to another. For example, it may make sense to elect an S Corp Status when you’re grossing $80,000 a year. However, if you have a lot of expenses, this figure can easily increase from $100,000 to $120,000 to make sense for you. You need to be paid reasonable compensation, too, which we’ll be covering below in more detail.
- Accounting. Do you have a good accounting method in place? If you’re only calculating expenses right before tax season, it can be difficult to know if electing an S corp makes sense for you. S corps also must run payroll, and you need to have your books up-to-date and accurate.
- Complexity. An S Corp does add complexity, so you need to either outsource some of the work or be comfortable with taking on more work to operate your S Corp and meet the added requirements.
*If your state doesn’t require you to be a PLLC, then you may be an LLC. For this article, we’re assuming you’re in a state that requires you to have a PLLC.
Understanding Reasonable Compensation
An S Corp requires something called “reasonable compensation.” What this means is that a shareholder – you, for example – need to be paid reasonable compensation for the services that you provide.
The IRS will scrutinize these payments to ensure that you’re not just trying to avoid employment taxes.
You can do this by listing all of the tasks that you complete, calculate the hours spent on different tasks and then determine how much you would be paid hourly for each task.
An S Corp can be a major component of your tax planning strategy, but it needs to make sense for your business. If you can tick off the boxes above, it may be time to elect as an S corporation.
Brook Bay Consulting can help you decide if electing to become an S corporation is the right choice for your private practice.
Click here to schedule a call with one of our tax professionals.