After years of listening to my accountant recommend this course of action, I’ve finally changed my freelance business to an S Corp election.
Pretty much since I switched accountants, Eric Nisall been trying to convince me to change my tax election to S Corp. And, finally, after gently reminding me to “consider” it for four straight years, I’ve taken the plunge.
I celebrated this whole S Corp election thing by also setting up with Gusto to manage the payroll. This combination is already making me happy and saving me a world of inconvenience.
Before we dive in, remember — I’m not a tax professional. This is not advice, and what works for me might not work for you. Consult with a knowledgeable tax professional before you move forward.
Here’s what I did and (presumably) how it’s helping my freelance business.
Changed My Freelance Business to an S Corp Election
Ok, so what does that mumbo-jumbo actually mean? Basically, I had to fill out a form telling the IRS that I want my business treated as an S Corp for tax purposes.
- I didn’t have to change my business structure — I still have an LLC
- Now my clients aren’t supposed to send me 1099-MISC forms — at all
- I have to follow stricter payroll procedures — and that’s ok
To make this happen, all I had to do was fill out a Form 2553 and send it to the IRS. It was very straightforward. My accountant was available to answer questions, but it really wasn’t an issue. I submitted mine to make the change on January 1, 2020, to make it clean and easy. However, I did send in the form back in November, just to have it done.
Realize that, as an LLC, you have flexibility in choosing how you want to be taxed as an entity. As far as the State of Idaho is concerned, I’m still an LLC. I didn’t have to change my articles of organization or set up a new business. Everything continues as it has. The only difference is that now the IRS will tax me as an S Corp.
My next move is to fill out a new W-9. Your W-9 isn’t actually about your actual business structure. Instead, it’s about how you’re classified with the IRS. As a result, I’m no longer being taxed as a sole proprietor, which was where I was at as a single-member LLC for several years after my divorce. (I had to dissolve my old business, with my ex for my partner.)
I’m actually planning on sending out the newly-completed W-9 forms out with my next invoices, along with a note pointing out that I’ve changed to an S Corp election and there will be no need to send me 1099-MISC forms.
Considering I still get 1099s, even though many of my clients shouldn’t be sending them because of the 1099-K, I’m sure this won’t end my pain. But it should hopefully reduce it a little.
Saving on Taxes with an S Corp Election
One of the main reasons to switch your freelance business to an S Corp election is to save on taxes.
Now, let’s be clear. This doesn’t change what I pay in income tax. That’s still pass-through, regardless of my tax election. All of it gets reported as income tax. What changes, though, is what’s considered self-employment tax.
With the S Corp election, I had to set up payroll and I now have to pay myself a salary. So, instead of paying the self-employment tax, I have to pay FICA taxes. Also, because I’m still the employer, I’m paying both sides. My business pays the employer side of FICA, and the employee side of FICA comes out of my regular paycheck.
However, those FICA taxes are only assessed on my salary. In the past, everything I made was subject to the self-employment tax. Now, only what’s paid as salary is subject to FICA, and I won’t pay the self-employment tax. I can take extra distributions from my business, and those won’t be subject to the self-employment tax (although I still have to pay regular income tax on the distributions).
Caveats to the S Corp Election
There are a few things to keep in mind before you get too excited. First of all, it might be tempting to just pay yourself a low salary. After all, you can pay yourself $30,000 a year and then just take everything else as a distribution, right?
Not so fast.
The IRS takes a look at businesses that are out of whack when it comes to the salary-to-distribution ratio. If your freelance business brings in $150,000 a year, and your K-1 (you’ll need one of those if you’ve got an S Corp election) shows $120,000 in distributions, and your salary is $30,000, that’s a red flag.
A big red flag.
Make sure you have a reasonable salary. Don’t let your distributions get out of hand. A good accountant will help you manage the ratio so that you still some savings, but don’t run afoul of the IRS.
Social Security benefits
Another consideration is Social Security. Your benefits are based on how much you pay into the system. If you pay less in FICA, you’ll have smaller benefits later. So keep that in mind.
I made it a point to choose a salary that was high enough to be reasonable for the IRS while also ensuring that my FICA is enough to meet my Social Security needs (assuming, of course, it still exists in 30 years).
Obviously, I’m not relying on Social Security for my retirement income. However, I also want to make sure my bases are covered.
You must keep better records
One of the reasons I took so long to get an S Corp election for my freelance business is because I’m lazy. The record-keeping! The payroll! Making sure I’m in compliance with tax payment requirements!
With the LLC, you just make your quarterly payments and pay your shortfall at tax time, and you can be a little sloppy with your records. It’s best practice, of course, to have separate business and personal accounts (and I have). But you can just move the money to yourself willy-nilly, and there’s not a lot of record-keeping.
Now, with the S Corp election, I need to make sure I’m meeting the requirements and maintaining a proper payroll. The only reason it’s working for me is that I signed up for Gusto and paying them to manage my payroll.
Managing Your Freelance Business Payroll with an S Corp Election
So far, I’m a little more than a month into this, and it’s been a bit brutal. I can see how it will help in the future but in order to set up a payroll system that allows you to pay taxes properly, there are a few hoops to jump through.
Get set up with your state
You need to get set up with your state if you want to manage payroll. If your state collects income tax, you probably need to set up an account. You’re also going to need to pay into the unemployment insurance fund.
And don’t forget that — if you have other employees — you might need to pay for workers compensation insurance. My state doesn’t require workers comp if I’m the only employee, but your state might be different. Check into the requirements so you know what you’re getting into.
When I set up with my state, I had to get:
- Tax account and associated number
- Tax payment account and associated number (along with a PIN)
- Separate unemployment insurance account and associated number
It was a bit of a pain, and it took several weeks to get it set up, I got there in the end.
Make regular tax payments
Don’t forget to make regular tax payments. You need to make sure you’ve calculated the correct withholdings for federal and state taxes. Remember — you’re not just withholding FICA taxes for yourself as an employee. You’re also withholding their income tax at the federal and state level.
I set up with my state to pay into their system regularly, and you also need to send in payments to the federal government. If you don’t stick with the schedule, you could end up in big tax trouble later.
Use a payroll service to make it easier
Because I hate all that effort, and because I’m a big fan of outsourcing, I’m not bothering with the logistics. I signed up for Gusto and am using them to manage my payroll. I still had to sign up for accounts with my state, but Gusto had step-by-step instructions for what I needed to do in Idaho.
Now, I do have two different accounts to make this work. I have a Gusto account as a business and a separate account as an employee. Each account has its own email address and log in information. It’s a little inconvenient that I can’t just switch back and forth, but really, all things considered, it’s not a big issue.
After providing all the account information to Gusto, they figure out the payments. I had to fill out a W-4 as the employee to figure out my withholdings, but it’s no big deal. I gave myself a reasonable salary and set up a weekly payment schedule.
Gusto takes the money from my business account, and then after taking care of withholdings, puts the money into my personal account as a direct deposit. They will also pay my taxes to Idaho and the IRS and issue Miranda-the-employee a W-2 at the appropriate time.
I like it because I don’t have to try to remember to make my quarterly tax payments and Gusto does all the heavy lifting.
After a couple of payrolls, I did end up giving myself a “raise” and I changed the payment schedule. It was a little rough at first, but now that I’ve had a few pay cycles, it’s much easier to manage and the cash flow works well. A little tweaking did the trick.
Depending on your situation, your freelance business might benefit from an S Corp election. Take the time to weigh the pros and cons. Even though it took some extra time to set up, the reality is that now things are smoother and easier for me. In the long run, it will save me time — and money.