In the last few years, the number of people who work as consultants on their own has grown quickly. These professionals have embraced the flexibility and independence of running a business single-handedly.
But with this freedom comes the responsibility of figuring out how to handle your taxes well. One effective tax planning strategy for consultant solopreneurs is converting their LLCs to S-Corp tax status with the IRS.
This article will discuss the benefits of this change and how it can make a consultant’s tax burdens much lighter. It will also talk about how important it is to follow the IRS’s rules for reasonable compensation.
Why Choose to be Taxed as an S-Corp?
Self-Employment Tax Savings
Saving on self-employment taxes is one of the main reasons to switch from an LLC to an S-Corp tax status.
As a solopreneur operating under an LLC, your net income is subject to self-employment taxes, including the employer and employee portions of Social Security and Medicare taxes. Unfortunately, this can mean that you have to pay a lot of taxes on your earnings.
By converting to an S-Corp tax status, you can classify a portion of your income as salary and the remaining portion as a distribution. Self-employment taxes will only be taken out of the portion that goes to the salary.
The part that goes to the distribution will not be taxed. This can help you save a lot on self-employment taxes, so you can keep more of the money you’ve worked hard for.
Reasonable Compensation and IRS Compliance
When choosing an S-Corp tax status, it’s important to follow the IRS’s rules about reasonable compensation.
The IRS requires that S-Corp shareholder-employees receive a reasonable salary for their services before taking any distributions. This means you can’t just lower your pay to avoid paying self-employment taxes.
When deciding reasonable pay, the IRS looks at many things, such as the employee’s role, responsibilities, hours worked, and pay rates for similar jobs in the same industry.
If you don’t pay yourself a reasonable salary, you could be audited, fined, or have your distributions reclassified as wages, which could cancel out the tax benefits of being an S-Corp.
Potential Income Tax Savings
In addition to saving money on self-employment taxes, S-Corp tax status may also save money on income taxes.
By splitting your income into a reasonable salary and distribution, you may be able to reduce your overall taxable income, potentially moving you into a lower tax bracket.
Furthermore, as an S-Corp, you can take advantage of certain tax deductions that may not be available to LLCs, such as the 20% qualified business income (QBI) deduction.
An S-Corp is like an LLC in that it has limited liability. This means your personal assets are generally safe from your business’s debts and liabilities.
Even though this benefit isn’t unique to S-Corps, it’s important to know that you won’t lose it if you change your LLC to an S-Corp for tax purposes.
How to Change the Tax Status of Your LLC to an S-Corp
Changing your LLC’s tax status to that of an S-Corp is a pretty simple process. You’ll have to send the IRS Form 2553, “Election by a Small Business Corporation.”
This form must be sent in within the first two months and 15 days of the tax year for which the choice will take effect.
It is essential to consult with a tax professional or attorney to ensure that you meet all the necessary requirements for the S-Corp tax status and properly navigate the conversion process, including determining and documenting reasonable compensation.
By switching your LLC to an S-Corp tax status, consultant solopreneurs can reduce their tax burden while still getting the benefits of limited liability.
By carefully adhering to IRS guidelines on reasonable compensation and working closely with tax professionals, you can optimize your tax savings and improve your overall financial position.
In the end, switching to an S-Corp tax status can help solopreneurs focus more on growing their consulting business and less on the complicated rules of taxes. This can help them be more successful and give them more financial freedom.