Episode 231: My S Corp Cost Me MORE in Tax Last year

On today's episode of the podcast, I explain how my S Corp ended up costing me more in tax last year. 

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Long story short, I should not have formed my S Corp last year because I didn't end up making as much money as I thought I was going to. Unfortunately, we can't always predict these things. 

I talk to a lot of business owners who have accountants that get them set up with an S Corp from day one. This is usually a bad idea, unless you're bringing a whole book of business with you from elsewhere and are starting your business at six figures. 

To exemplify this, I will use my own numbers, especially since 2021's revenue was less than I anticipated. I was about $50,000 under the minimum revenue I projected when I started my S Corp and I was $100,000 under my goal. I ended u making about $95,000 last year, and $140,000 the year before. I thought I would continue to double year over year, or at least hit $200,00. I formed my S Corp in January 2021 and immediately got on payroll so I had an S Corp for effectively the whole year. 

When you have an S Corp, you pay yourself a salary, through a payroll provider that holds your taxes for you and divides them out to the various government agencies. Only your salary in an S Corp is subject to self-employment taxes. As business owners, we are required to pay both income taxes and full self-employment taxes which is our share of Medicare and social security. When we're employed, we pay half and our employer pays half. When we're self-employed, we pay both halves. The S Corp allows you to split your payment into two types - salaries and distributions - where only one of those is subject to 15.3% self-employment tax. This allows you to save 15.3% tax on any profit you have above and beyond your salary but your salary must be reasonable under law. 

For example, assume you have $100,000 in gross revenue and you operate at 80% gross profit meaning you only have $20,000 in business expenses. That would make your profit $80,000. You do research and determine your reasonable salary should be $60,000. In an S Corp, you pay this salary through payroll and it is technically an expense, but doesn't mean you don't pay taxes on it. This leaves you with $20,000, I call this profit after reasonable salary which is the amount of money you have after all your business expenses and your owner's salary. This is also your distribution amount. You save a 15.3% self-employment tax on the remainder, which leaves you with $3,060 in tax savings.

As this relates to my S Corp last year, I had $95,000 in revenue, but a slightly negative profit on my tax return. How does this happen? Previously I've talked about profit on your books versus profit on your taxes. This is correct, and totally normal. A big example is home office. We should not pay our rent or mortgage out of our business bank account because it is a mix-use expense so it comes out of our personal account and then have our business reimburse us for the use of our home office if you have an S Corp. Mine was about $5 or 6,000 which combined with a few other examples like this, took me to a slight negative profit on my tax return. It's important to note this doesn't mean you didn't make any money from your business, we're just talking about business profit. 

A S Corp saves you money by having profit after reasonable salary, which I did not have. It cost me about $600, which is the cost of my payroll. The biggest issue for me was the QBI (Qualified Business Income) deduction. This allows business owners to deduct 20% of their QBI (see line 13 of the 1040 tax form). We can simply this to say it's basically net business income with some exceptions. This only identifies to passthroughs. Income phaseouts and the rules for phaseouts differ based on the kind of business. 

To see the Qualified Business Income decision tree to see the rules and break down the limitations, click here. What I want you to know is the QBI deduction gives you a 20% deduction on your qualified business income which is most of your income unless you hit certain phaseouts at different levels of income which is what we cover in the decision tree. 

When you have an S Corp. you have less QBI because your salary is treated as an expense. QBI in an S Corp is the net income after salary. We can calculate the tax savings by multiplying the deduction by the marginal tax rate. If you file your S Corp at the right time (which I did not) then the amount that you're going to save is going to offset the amount you're going to lose in the QBI deduction.

This year I should be fine, I'm on track to make $140 to $180,000. As a sales person, it's easier for me to say an S Corp will sell you taxes and you can pay me $X to set it up for you, but I'm not going to sell you on that. I want you to understand the nuts and bolts which is I have Profit Rx. You can join beginning at $30/month, upgrade to a VIP tier to get group support, or join our seasonal membership to get 1:1 support.