{"id":2713,"date":"2015-12-01T05:18:53","date_gmt":"2015-12-01T13:18:53","guid":{"rendered":"http:\/\/evergreensmallbusiness.com\/?p=2713"},"modified":"2024-08-30T10:29:22","modified_gmt":"2024-08-30T17:29:22","slug":"blue-collar-s-corporations","status":"publish","type":"post","link":"https:\/\/evergreensmallbusiness.com\/blue-collar-s-corporations\/","title":{"rendered":"Blue Collar S Corporations"},"content":{"rendered":"

\"Picture<\/a><\/p>\n

I watched the CNBC television show, \u201cBlue Collar Millionaires\u201d over the summer.<\/p>\n

A good show, episodes (rightly) hammer home the point that America provides tons of great small business opportunities for entrepreneurs who don\u2019t mind working with tools or coming home with a little dirt on their clothing.<\/p>\n

The show has gotten me thinking, though, about something else. Which is this: How profitable a blue collar business do you need in order to justify an S corporation?<\/p>\n

Fortunately, if you\u2019ve got a blue collar business, or really any small business,\u00a0you can answer this question by looking (briefly) at the cost of an S corporation and then at the typical benefits an S corporation delivers.<\/p>\n

I\u2019m going to try and help you do this here by talking about the costs to set up a small \u201cblue collar\u201d S corporation. And by also looking at the impact of Subchapter S status on three example businesses. One business making $40,000 a year, another business making $80,000 a year, and a third making $120,000 a year.<\/p>\n

Tip:<\/strong> Use our free calculator to estimate S corporation tax savings for your situation: S Corporation Tax Savings Calculator<\/a><\/p>\n

Costs to Set-up Blue Collar S Corporation<\/h2>\n

Okay, just to get this awkward bit out there first, probably you will pay at least a few hundred dollars to set up an S corporation and then pay one to two thousand dollars a year to operate the S corporation.<\/p>\n

States, for example, charge you modest one-time fees for forming an LLC or corporation (often $100 to $200). But the good news is, you can usually do the paperwork yourself using free online forms or working with online applications supplied by your state\u2019s Secretary of State. (You can also get additional help by looking at the\u00a0short, step-by-step instructions available at this blog\u2014just click on the LLC Formation Kits link at the top of this webpage and select your\u00a0state from the list that appears.)<\/p>\n

Another cost to consider: Operating an S corporation does bump your annual accounting costs in a couple of areas.\u00a0You will pay a few hundred dollars in additional\u00a0payroll taxes for unemployment insurance to either your state or to the IRS. \u00a0You\u2019ll also probably \u00a0need to pay a CPA or enrolled agent a thousand dollars or so to prepare the more complicated, new, corporate tax return you need.<\/p>\n

Finally, one last cost to remember: You may in some states pay substantial annual fees or franchise taxes simply because you have an S corporation. (California is the worst, I think, and charges you nearly a $1,000 a year no matter what your business earns in the way of profits\u2026 so read this blog post<\/a> if you\u2019re in California.)<\/p>\n

In summary, then, an S corporation costs a few hundred bucks at least to set up. \u00a0And it\u2019s easy to find yourself paying maybe $1,500 in extra annual accounting costs.<\/p>\n

The question, then, is when does a blue collar business save money by operating as an S corporation?<\/p>\n

The $40,000-in-Profits Small Business<\/h2>\n

Let\u2019s look at a really common case first\u2014the case where a small business makes a profit to the owner of $40,000.<\/p>\n

Note that this might be a business with $50,000 in revenues and $10,000 in expenses, because $50,000 minus $10,000 equals $40,000.<\/p>\n

Or this might be a $400,000 business with $360,000 in expenses, because $400,000 minus $360,000 equals $40,000.<\/p>\n

Can an S corporation work in a situation like this? Well, it\u2019s tricky. And here\u2019s why.<\/p>\n

If a business operates as a sole proprietorship and makes $40,000 in owner profits, the proprietor pays a 15.3% self-employment tax on the $40,000.<\/p>\n

Note:<\/strong> The actual self-employment tax formula is a little bit complicated because for purposes of the formula, you adjust the profit number for half of the self-employment taxes. But you can ignore this complexity for purposes of our discussion.<\/p>\n

If this business operates as an S corporation, the business owner will need to pay the 15.3% employment tax only on the portion of the profit that he or she calls \u201cwages.\u201d The business owner, therefore, avoids paying the 15.3% tax on the extra leftover amount that\u2019s not called \u201cwages.\u201d<\/p>\n

Avoiding the 15.3% tax on a chunk of the business profit is<\/em> the tax benefit you get when you operate as an S corporation<\/p>\n

But here\u2019s the problem. The business will need to pay its owner a reasonable wage. That\u2019s the rule. And probably in a situation where the profits equal $40,000, most and possibly even all of the profits will need to be called \u201cwages.\u201d<\/p>\n

So in the $40,000-in-profits scenario, the business owner may pay a few hundred dollars to set up the S corporation. He or she may pay, gosh, $1,500 a year in extra taxes and CPA fees to operate as an S corporation.<\/p>\n

And then because the owner needs to take all of the $40,000 of profits as wages, he or she will still pay that 15.3% tax on all of the business profits.<\/p>\n

In this scenario, probably, the S corporation doesn\u2019t work to save the entrepreneur payroll taxes. Sorry.<\/p>\n

The $80,000-in-Profits Small Business<\/h2>\n

Okay, what about a situation where the business generates $80,000 in profits for the owner?<\/p>\n

Well, oddly enough, even though this situation doesn\u2019t seem that radically different from the $40,000-in-profits business\u2014this may simply be the same business five years farther down the road\u2014this business probably can save money.<\/p>\n

In a situation where a small business earns $80,000 in profits and operates as a sole proprietorship, the owner pays that 15.3% self-employment tax on roughly $80,000. When you work out the actual tax bill, due to the formula complexities mentioned earlier, the actual self-employment tax bill will be a little less than $12,000.<\/p>\n

But here\u2019s the deal: The typical S corporation pays its shareholder-employee $40,000 a year in wages. And if $40,000 is the reasonable \u201cwages\u201d number, the business owner will only pay the 15.3% tax on this $40,000 chunk of the profits. That\u2019ll equal roughly $6,000.<\/p>\n

In this case, the business owner saves nearly $6,000 a year in payroll taxes.<\/p>\n

The bottom-line? Even if the corporation costs a few hundred dollars to set up and costs (say) $1,500 a year to operate, probably the S corporation option begins to look attractive.<\/p>\n

Note, too, that in a situation where a fifty-fifty split between \u201cwages\u201d and \u201cnon-wages\u201d doesn\u2019t work because $40,000 in wages isn\u2019t reasonable, a clever accounting can still produce nearly $6,000 of savings.<\/p>\n

I\u2019m going to talk more about this in the next section, but mechanically, amounts a shareholder-employee receives for health insurance, health savings accounts, and pension plan contributions such as a SEP-IRA either count as wages but aren\u2019t subject to the 15.3% tax or they reduce the \u201cnon-wages\u201d amount the IRS gets cranky about.<\/p>\n

The $120,000-in-Profits Small Business<\/h2>\n

With a $120,000-in-profits small business, the tax savings associated with an S corporation often become irresistible.<\/p>\n

If such a small business pays its owner $40,000 in \u201cwages,\u201d that means he or she saves paying the 15.3% tax on roughly $80,000 of additional business profits and therefore enjoys nearly $12,000 in annual payroll tax savings.<\/p>\n

Clearly, spending a few hundred bucks and maybe $1,500 a year to annually save nearly $12,000 in payroll taxes is a great deal.<\/p>\n

In fact, quite honestly, this scenario produces such giant savings, it\u2019s probably a little suspect. \u00a0Or worse.<\/p>\n

Remember the rule of S corporation compensation mentioned earlier: Your S corporation needs to pay you reasonable wages.<\/p>\n

However, even a $40,000-ish in base wages scenario might in many situations work.<\/p>\n

You want to confer with your CPA about this, but here\u2019s an example of how a $120,000-in-profits small, blue collar business might be able to save nearly $12,000 annually in payroll taxes.<\/p>\n

Suppose the base salary you pay yourself equals $42,000. Further, suppose that your corporation pays $10,000 a year for your family\u2019s health insurance and also makes a roughly $8,000 health savings account contribution. In this case, only the $42,000 base salary gets subjected to the 15.3% payroll tax\u2026 yet the health insurance and health savings account amounts count as wages, too.<\/p>\n

If you set up a pension plan that allows for a 25%-of-wages employer contribution, that means you essentially add another $15,000 to your employee compensation (25% of the $42,000 in base wages plus $$10,000 of health insurance plus $8,000 in health savings account)<\/p>\n

With these numbers, you might enjoy roughly $75,000 in wages and tax-free fringe benefits, which may be enough to qualify as \u201creasonable.\u201d Yet only $42,000 will be subject to the 15.3% payroll tax.<\/p>\n

And then note that you still have another $45,000 in leftover profits in this case on which you have avoided the 15.3% payroll tax. This is the chunk of business profits the IRS may want to talk to you about\u2026 but it very possibly might not cause the IRS any problems. You may, for example, leave some of this money in the business to fund growth\u2014and the IRS won\u2019t care about not collecting the 15.3% tax on that reinvested profit. And then\u00a0you should be able to draw some money out of the business as \u201cnon-wages\u201d just because the shareholders should be entitled to a return on their investment.<\/p>\n

Closing Caveats and Comments<\/h2>\n

Can I share some quick, random caveats and comments in closing? Good.<\/p>\n

First, you can use either an LLC or a corporation as the \u201cbase\u201d of an S corporation. I commonly recommend people use an LLC because limited liability companies\u00a0often are easier to set up and operate. (Here\u2019s a page <\/a>where I talk more about this choice.)<\/p>\n

Second, you will need to do a couple of \u201cpaperwork\u201d tasks after you get your LLC or corporation set up: First, get your new LLC or corporation an employer identification number (something I describe here<\/a>). And, second, formally elect to Subchapter S status (something I describe here<\/a>).<\/p>\n

Third, I\u2019ve got another blog post here that describes how to avoid state-level payroll taxes<\/a> in a handful of states. You probably want to peek at that.<\/p>\n

Fourth, if you\u2019re a Washington state S corporation, check out this checklist for a first-year Washington state S corporation<\/a>.<\/p>\n

Fifth and finally, you really, really, really<\/em> do need to be careful about how you set your compensation. Goof that up and you\u2019ll (in a worst case scenario) find yourself in hot water with the Internal Revenue Service and possibly with your state\u2019s unemployment insurance folks, too. (You might want to consider our downloadable ebook on setting S corporation salaries\u00a0available here<\/a>.)<\/p>\n

Are You a Small Business Owner Looking to Reduce Taxes?<\/h2>\n

\"\"<\/a>Small business owners often don’t do a good job with\u00a0maximizing their legitimate tax deductions.<\/p>\n

For example, business owners usually\u00a0don’t go to the effort of structuring their operations to protect legitimate deductions, to create new deductions and to recycle (or double-deduct) the deductions which can be used more than once to save taxes.<\/p>\n

Which is really too bad. Getting disciplined and smart about small business tax deductions can save businesses and their owners a bundle in taxes.<\/p>\n

If you’re thinking maybe you can do a better job with your tax deductions, consider downloading\u00a0our $40 e-book, Small Businesses Tax Deduction Secrets<\/em>. This short e-book\u00a0provides detailed instructions\u00a0about how business owners can annually save thousands or even tens of thousands of dollars in income and related taxes simply by more effectively using legitimate small business tax deductions.<\/p>\n