Downside to S-Corp Election
Not everything that glitters is gold. There are a few manageable downsides to the S-Corp election. First, paying owners through payroll and filing a corporate tax return costs money- but with the example above, the savings will likely exceed the costs. And since the cost of payroll services and corporate tax return preparation is relatively fixed, the more profit you earn the more you’ll save. Something to discuss and consider.
Second, S-Corp shareholders are distributed profits as a percentage of ownership whereas garden variety LLCs use an operating agreement. This can create headaches for silent partner situations, and other non-traditional ownership structures.
Lastly, if you believe social security will remain funded by the time you retire, you might be short-changing yourself since your salary will be used to gauge future retirement benefits. Remember, owner distributions not subjected to self-employment taxes will not count towards your social security benefits basis. There are some other retirement hiccups that could affect your decision, and since they are very specific and detailed, more discussion is required. Keep in mind that the tax money you save today can make excellent retirement investments.
As a side note, it is NOT a good idea to make an S-Corp election on your LLC if it owns rental property. Rental property by definition is passive income (unless you are a real estate professional) and therefore not subject to self-employment tax. But if you run your rentals through an S-Corp LLC, you will be required to perform payroll which means you’ll be paying FICA and Medicare taxes which are the same as self-employment tax. Don’t do it.
Reasonable Salary, Payroll
This is the million dollar question. The IRS through Fact Sheet 2008-25 released a laundry list of factors used in determining a reasonable salary. It doesn't offer a lot of help. A jumping off point is 50% of net profits. Keep in mind that other employee salaries, 401k contributions, putting your kids on the payroll, taking money out through expense reimbursements and paying down shareholder loans all go into the mix too. And if you are one-person show, all you need is quarterly payroll (4 per year- super simple).
