You’re a freelancer or solopreneur with a growing business. You are making money on the side (yes, legally, what kinds of clients do you think I have!), hoping you’ll soon be able to quit your “official” job. Of course, you’re an independent contractor, which means you get a 1099. But is that what’s best for you? Or is there a better way?
If you get a 1099, you are paying the IRS the more than you ought to. And if you haven’t heard, the IRS wants more even more 1099s. Maybe you’ve heard that you could form an S-Corporation (S-Corp) to save taxes, but you’re not sure if that’ll work for you. You don’t need to guess anymore. I’m going to demystify S-Corps vs 1099s, and teach you how to make the best choice for you, so you keep more of your hard-earned money, and give less to the IRS.
S-Corp vs 1099: these should be a few of your favorite things to know
- What are the 3 most important reason for you to form an S Corporation?
- Self-employment tax, the 1099’s most brutal tax
- How much does it cost to become an S-Corp?
- How do I change from 1099 to S-Corp status?
What are the 3 most important reason for you to form an S-Corporation?
1. Clients take you more seriously. Why? Because you’re taking yourself more seriously. Honestly, whom do you trust more, some fly-by-night “yeah, I do consulting” dude, or the “I have my own firm” person?
2. Liability protection. If one of your clients does sue you, guess whom they actually have to sue: not you, but your S-Corp. That’s a powerful liability shield (of course, always consult with your attorney for details: this is not legal advice). That’s because they’re doing business with the entity, not with you, who is simply an employee of the S-Corp. Thus, your S-Corp, if organized correctly (again, talk-to-your-lawyer time), can protect and shield your personal assets (e.g., your home, stocks, rentals, etc.) from lawsuits. When they have to sue the S-Corp., but the S-Corp. doesn’t own anything, then they get a big fat nothing!
3. Lastly, but truly not least, the most important benefit is that you pay less tax, specifically less self-employment tax.
Self-Employment Tax, the 1099s most brutal tax
Taxation is brutal, but there are still degrees of brutality. The self-employment tax, also known as the payroll tax, as FICA, or as the Social Security-Medicare tax, is perhaps the worst offender here. For the small businessperson, it is little better than the Inquisition, and I don’t mean the Monty Python version either. Instead of stretching you on the rack, they pry open your bank accounts and want everything in them, specifically, an extra 15.3% tax on your net income.
Here’s an example: suppose you’re a 1099 independent contractor making $100,000 in net profit. You will have to pay an EXTRA $15,300 in self-employment tax on top of your income tax. But if you turn your business into an S-Corp, you no longer have to pay Self-Employment tax on all your net income. Instead, you only pay it on the salary you pay yourself from the S-Corporation. If your salary is a lot lower than the net income, you are going to save a LOT of tax.
Using the example above, your business is an S-Corp and you pay yourself a $60,000 salary. You will now pay the extra 15.3% tax on $60,000 ($9,180), not the full $100,000.
That’s a tax savings of $6,120. This is why all small businesses should want to become S-Corporations!
How much does it cost to become an S-Corp?
Becoming an S-Corp is not cheap. This is a long-term benefit. You have to pay to play. Therefore, you need to make sure that the cost will be more than enough to offset your tax savings. The most common expenses associated with S-Corps are:
- Licensing fees to your state. These vary. For instance, in California they charge you $800 per year. In Texas, they charge you $300–and only in the year you start. (Everything in Texas is bigger, except the tax burden, it appears.) Further, most states adhere to the Britney Spears “Baby, One More Time” philosophy by charging you an annual fee. California (shocking!) and Nevada do this, for example.
- The cost of filing your Corporate Tax Return. Most CPAs will charge anywhere from $1,000 – $2,000 per year for this.
- The cost of setting up payroll for your salary. Now that you’ve got a S-Corp, you’re going to have to put yourself on payroll. If you are the only employee of your S-Corp, companies like Gusto and Rippling will charge you around $500 – $600 annually. If you have more employees, then expect your payroll fees to be higher.
- State Unemployment Taxes. Most states charge around 3% in extra payroll taxes for unemployment.
Let’s take Nevada as an example. Suppose your S-Corp costs are $3,450 ($650 for your annual fee to the state, $1,200 to file your tax return, $600 for your yearly payroll processing, and $1,000 for state unemployment tax.)
If your business makes less than $100K a year in net profit, you will save money by becoming an S-Corp, since that’s less than the $6,120 above.
How do I change from 1099 to S-Corp status?
Whenever the subject is saving taxes, you had better believe that the IRS will be standing in your way. As Walter Sobchak so eloquently states in The Big Lebowski, there are rules. Let’s look at the IRS’s:
- First, you must get an EIN (employer identification number) from the IRS. This is perhaps the only thing in the world the IRS will give you free.
- Your business must be incorporated in the United States (sorry, Canada, you are SOL, no maple leaf for you).
- You may have only a single class of stock (that means no preferential stock, i.e., all shareholders must be treated the same).
- You must have fewer than 100 shareholders.
- All the shareholders must be U.S. Citizens or legal residents. That also means other LLCs, corporations or partnerships cannot be shareholders, just actual people.
- You must file special paperwork with the IRS to inform them that you are now The Big Cheese, a bona-fide S-Corporation (Form 2553, Election by a Small Business Corporation).
There’s more to know, but these are the keys. Since every solopreneur’s journey is different, always reach out to a CPA to be sure you’re not missing anything and that you’ve got your t’s crossed and i’s dotted.
Next month, with this under your belt, and just in time for Labor Day, I’ll walk you through the exact process of becoming an S-Corp.