Small business owners prefer to organize their businesses as LLCs, and for many the best tax strategy is to have their LLC taxed as an S Corp. This strategy allows owners to effectively manage the amount of Social Security and Medicare taxes they pay. Sometimes this strategy can be complex to execute and small business owners face a few scenarios calling for extra caution.
The tax structure of LLCs can take four possible forms. There are two default tax structures: single-member LLCs (SMLLC), which are disregarded entities, and multi-member LLCs (MMLLC), which are taxed as partnerships. In addition, the member(s) can elect to be taxed as a C Corp or S Corp. Since most small businesses won’t benefit from a C Corp election, it’s rarely used, and the decision is left between default tax structure or S Corp election.
These tax structures, except C Corps, are flow-through entities which means that the owners pay personal income tax on the income generated by the businesses. The tax savings come from the nuances in the tax code, however not all these nuances are in favor of S Corps. Keep these S Corp pitfalls in mind next time you talk to your accountant.
The Social Security cap
The majority of the tax savings for S Corps come from reduced Social Security taxes. Thus, if your small business is a side gig and you have a full-time job elsewhere making over the Social Security cap—143K for 2021—then you lose most of your tax benefit. Furthermore, since you still have to pay the employer side of Social Security, you might actually pay more. It’s always important to take a holistic view of your taxes in order to optimize your tax strategy.
Loss of allocation control
The number of distributions and the flow-through of income/losses is irrelevant for a SMLLC-disregarded entity but it can make a big impact for MMLLCs. Flow-through can be better controlled if an MMLLC is taxed as a partnership rather than an S Corp since you are allowed to allocate different percentages for income and loss flow-through. An S Corp doesn’t have this flexibility and must follow ownership percentages. While this restriction won’t typically impact SMLLCs, it can easily mean loss of tax benefits for MMLLCs.
Failing to set up payroll
Regardless if S Corps or C Corps, corporations must pay owners who work in the business through W2, while a SMLLC-disregarded entity or MMLLC-partnership has no payroll requirement. Thus, it is imperative that S Corp owners set up payroll for themselves. Some business owners try to circumvent this by paying themselves via 1099, but an owner is not independent and thus cannot be paid via 1099. Failure to set up payroll can mean extra penalties if the IRS retroactively reverts the S Corp election.
More filing penalties
An MMLLC-partnership and LLCs taxed as S Corps must file separate income tax returns. In addition, S Corps will usually have quarterly payroll reports. The additional reports all carry failure to file penalties if they are not done on time. Small business owners need to pay attention to filing deadlines to avoid paying these penalties. A good accounting firm will help mitigate this risk, however the owners are ultimately responsible to ensure tax returns are filed on time.
Non-active businesses
For certain types of businesses, like real estate or investing, the tax advantages of S Corps don’t provide any benefit because the income is not subject to self-employment tax. Furthermore, the extra complexity of S Corps can actually cause some losses to be disallowed, thus increasing the amount of taxes. Business owners should always consider the type of income their business will generate when considering an S Corp election.
More often than not, the best tax strategy is to have your business taxed as an S Corp. It should provide you with enough tax savings to cover any additional accounting expenses. There are many considerations in any tax strategy and a profound discussion is recommended. While accountants will provide guidance and advice on correctly executing this tax strategy, business owners should also educate themselves so they can provide relevant information and ask appropriate questions.
This article originally appeared on Forbes