The end of the year is the perfect time to make a change to your business structure because doing so can afford you additional tax advantages in the coming year. While there are several business entity structures you can use for a freelance business, the S-corporation (S-corp) is worth considering.
S-corps, which are considered pass-through entities, have a unique tax structure given how their income distribution and loss limitations work and how and when income and expenses are taxed.
For example, all income in an S-corp is passed through to any shareholders and taxed at their individual tax rates. An S-corp's income is taxable for the shareholders when it is earned—whether or not the corporation distributes the income.
S-corp income and expenses are subject to special rules and separate identification for tax purposes, which may make the preparation of your taxes more complex if you are currently filing as an LLC or sole proprietorship. Examples of items which must be stated separately and could affect a shareholder's tax liability include charitable contributions, capital gains, Sec. 179 expense deductions, foreign taxes, and net income or loss related to rental real estate activities.
The items above, as well as income and losses, are passed through to the shareholder on a pro rata basis, which means that the amount passed through to each shareholder is dependent upon that shareholder's stock ownership percentage. However, a shareholder's portion of the losses and deductions may only be used to offset income from other sources to the extent that the total does not exceed the basis of the shareholder's stock and the basis of any debt owed to the shareholder by the corporation. S-corp losses and deductions are also subject to the passive-activity rules set by the IRS.
S-corps are the “King of Entities” for US Small Businesses
You may be thinking that the added complexity of the S-corp is a disadvantage, but it is worth noting that this type of entity offers several significant benefits, which is likely why the S-corp remains the "king of the entities" and the most popular form of businesses nationwide (aside from unincorporated sole proprietorships). So is an S-corp for you? Let’s look at their primary advantages and disadvantages:
Advantage: Payroll and income tax savings
As the owner of an S-corp, you (and any other shareholders) are essentially employees of the business when it comes to payroll and income taxes. You pay yourself a reasonable salary from the profits of your business (which are considered a business deduction) and it is the business (not you as an individual) that pays the requisite Social Security and Medicare taxes at the lower employer rate. The profits that are paid as salary are subject only to income taxes, netting you a nice tax savings in comparison to other entity types.
The IRS does provide guidelines for determining what is considered a “reasonable” salary for S-corp officers to prevent you from claiming all business revenue as such. How do you know what a reasonable salary is? The IRS suggests considering factors such as the time and effort individuals devote to the business, the duties and responsibilities they fulfill, their training and experience, any payments to non-shareholder employees, and what comparable businesses pay for similar services. It is advisable to take the time to establish reasonable salaries for yourself and any other shareholders so that you don’t become the subject of additional IRS scrutiny.
Advantage: Additional pre-tax savings for retirement contributions
As an employee-shareholder of an S-corp the opportunity exists for you to reduce your taxable income by investing in a 401(k) or other qualified retirement account. This can add up to considerable tax savings—plus a happier retirement—over the long-term.
Disadvantage: State and local taxes.
While the profits from an S-corp are generally taxed at a lower rate than those of other corporate structures, the state and local tax rates to which an S-corp is subject can often be the deciding factor as to whether it or not it makes sense to use this entity structure from a tax perspective. For example, in New York City, an S-corp would be subject to the city’s 8.85% business tax, on top of state and federal taxes. This could potentially increase the S-corp tax bill significantly and essentially wipe out the other tax advantages offered by this entity structure. This is why it is imperative for those considering an S-corp to be well aware of the obligations of their specific tax nexus.
Disadvantage: Less ability to borrow from creditors
Since S-corp owners receive a salary from their business, their ability to borrow for mortgages, car loans and other significant credit may be diminished if their salary is small. This is because traditional lenders such as banks typically factor in your earned income rather than the cash flow of your business when they make lending decisions. If you don’t have a high net worth or great credit and you foresee wanting to obtain a large loan in the near future, then you may not want to use an S-corp as your business structure.
The advantages and disadvantages outlined here are just a few of the factors to consider when looking at which entity type you should use for your business. Like any major business decision, it is wise to do your proverbial homework and seek the help of a professional—in this case a CPA or tax professional who is familiar with your local and state tax obligations—so you can make an informed decision on whether an S-corp or a different entity structure is right for you.
Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country. He offers a free consultation to members of Freelancer’s Union and a monthly email newsletter covering tax, accounting and business issues to freelancers on his website, www.cpaforfreelancers.com which also features a new blog, how-to articles, and a comprehensive freelance tax guide.
Jonathan is happy to provide an initial consultation to freelancers. To qualify for a free consultation you must be a member of the Freelancers Union and mention this article upon contacting him. Please note that this offer is not available Jan. 1 through April 18 and covers a general conversation about tax responsibilities of a freelancer and potential deductions. These meetings do not include review of self-prepared documents, review of self-prepared tax returns, or the review of the work of other preparers. The free meeting does not include the preparation or review of quantitative calculations of any sort. He is happy to provide such services but would need to charge an hourly rate for his time.