One of the questions I often get asked by my small business clients is whether it would be better to convert the LLC to an S-Corp. The thinking is that as an S-Corp owner, I’ll pay myself a salary on the low side, and all of the rest of my business income will not be subject to Social Security or Medicare tax. As is the case with most planning questions, the answer depends on the specific situation.
Let’s talk about two of the parts of this question.
Firstly, how the smaller salary will affect retirement.
Well, if the LLC generates $170K of net income, why not pay myself a salary of $70K and save $15,300 of Social Security plus Medicare taxes each year?
This is certainly a big consideration. However, even if the $70K is a reasonable enough salary to avoid IRS questioning, the phrase “save $15,300” is really misleading. The $15,300 of Social Security plus Medicare is really $12,400 of Social Security contributions plus $2900 of Medicare contributions. If you regularly pay yourself a salary $100,00 less than your total business income, you lower your Social Security contribution by $12,400 a year and when you retire, your benefits will be dramatically lower as well. The bulk of the savings now is better viewed as borrowing money against future Social Security benefits. Certainly the $2900 saving in Medicare tax is an important part of the picture.
When the business owner turns 50, I have him/her think long and hard about what retirement can look like with smaller Social Security benefits. CLICK HERE to start the calculation.
In addition to smaller Social Security benefits, the lower salary can lower other retirement benefits. Any qualified plan such as a 401(k) that an owner will want to set up only allows salary deferrals up to a percentage of W2 box 1 income. As an owner, minimizing your salary will minimize your retirement contributions now and as such your retirement benefits later.
Secondly — are you maintaining stellar business records now?
If the business owner has been using the LLC as a second bank account for personal expenses, converting to an S-corp makes the bookkeeping even messier. Now as a corporation, the basis of the business is being tracked. When the owner takes distributions in excess of basis, there are tax consequences. Or if the distributions are really loans, then the owner needs to sign a formal promissory note with the corporation with a market rate of interest. Absent the promissory note, a shareholder loan can be reclassified as salary by the IRS with the taxes, interest and penalties imposed on the “erroneous loan.”
The owner has to ask, “Can I actually be disciplined enough to stay within my means? Am I actually ready to make regular payments with interest?” Otherwise this mess can cost the owner money come tax time to actually clean it up.
The decision to convert to an S-corp has many ramifications and should be made after consultation with a tax professional.
This article was written by Moshe Pelberg, CPA, a contributor to Howard Courier.
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