Attention Real Estate Agents. Once the deal is done and you hand the keys to the homebuyer, it changes their life forever. Here is a key that may change your life. It’s known as the S-election. Use it to unlock massive tax savings by eliminating self-employment tax on your commissions. Additional paperwork and expenses are involved, but the tax savings are worth it.
Real Estate Agents have two options when it comes to reporting commission income to the IRS. The choice you make drastically affects your tax bill.
Use Schedule C which results in self-employment tax
Use Form 1120-S which eliminates self-employment tax
The following comparison assumes you earn $250,000 of commissions per year.
If you make the S-election there is no self-employment tax. You pay ordinary income tax as well as a small amount of FICA tax (FICA stands for Federal Insurance Contributions Act and is more commonly known as Social Security and Medicare tax).
If you don’t make the S-election you pay self-employment tax and ordinary income tax. As you can see by the chart, self-employment tax is a big deal that costs you a lot of money.
By making the S-election you save about $12,000 in taxes. Talk about a great tax saving strategy!
The S-election creates additional business expenses that lowers your profit. It seems counterintuitive that lower profit means more money in your pocket, but leave it to the IRS to come up with rules that allows this to happen. Lower profit means you pay less taxes, so at the end of the year your checking account has more cash under the S-election scenario.
If your goal is to minimize taxes and maximize cash, the S-election is perfect. The tax savings outweigh the additional filing requirements and related expenses.
The charts above use the following numbers:
Agent makes the S-election
Commissions earned = 250,000 Business expenses = 196,000 Profit = 54,000
Your 54,000 profit is hit with ordinary income tax.
Ordinary income tax on your profit = 8,100
Self-employment tax = 0
But the tax story continues…
You must pay yourself a reasonable salary to qualify for the S-election. The definition of reasonable is a grey area because the IRS does not provide dollar amounts. The general guidance is you should pay yourself however much you would have to pay someone else to do your job for you. This example assumes an annual salary of 40,000.
Your 40,000 salary is hit with ordinary income tax and FICA tax (FICA stands for Federal Insurance Contributions Act and is more commonly known as Social Security and Medicare tax).
Ordinary income tax on your salary = 6,000
FICA tax on your salary = 3,000
Adding these two amounts to the ordinary income tax leads to a total tax bill of 17,100.
It’s not free to make the S-election. You will incur the following business expenses each year:
Reasonable salary = 40,000 Payroll tax = 3,000 (this is different from the 3,000 of FICA you pay) Payroll service = 2,400 Corporate tax return preparation = 600 (definitely leave this to a professional)
TOTAL = 46,000
These expenses lower your profit, so you owe less tax which is a good thing. Another positive is the 40,000 salary gets deposited into your personal checking account net of income tax and FICA tax.
Agent does not make the S-election
Commissions earned = 250,000 Business expenses = 150,000 Profit = 100,000
Your 100,000 profit is hit with self-employment tax and ordinary income tax.
Self-employment tax = 14,000 Ordinary income tax = 15,000 Total tax = 29,000
The S-election cuts your taxes by 11,900. Huge difference!
If you want to proceed with making the S-election, start by forming a Limited Liability Company (LLC) and obtaining a Federal Employer Identification Number (FEIN). This is an easy process that only takes a few hours to do yourself, or you can pay a lawyer around six hundred bucks to take care of it for you (it’s worth it to pay the lawyer). Make sure the lawyer knows you plan to make the S-election.
The next step is to make the S-election by filing a short form with the IRS. You must get their permission to make the S-election, but almost everyone gets approved so it’s no big deal. You can fill out the form in thirty minutes, or you can pay a professional around two hundred bucks to take care of it for you (it’s worth it to pay the professional).
The final step is adding you to the LLC’s payroll because one of the conditions of maintaining S-election is you must be paid a reasonable salary. Use QuickBooks Online Payroll to take care of your payroll needs. It’s user friendly and the cost is in line with other payroll services.
Now everything is setup and ready to go. The LLC files an annual Form 1120-S tax return that reports your commission income and related expenses. Information from that tax return flows to your individual tax return (Form 1040) where income tax is calculated. The LLC does not pay income tax. That falls on your shoulders.
The S-election is a great tax strategy for real estate agents. Contact us now for more details.
JWTW Industries L.L.C. provides the information in this blog as a general guide. Tax laws are extremely complex, and every taxpayer is unique. Some or all of this information may or may not apply to you. We provide simplified situations to clarify some of the major aspects and highlights of the topic at hand. Some of the language used is casual and may be misconstrued. Please make an appointment with us soon to discuss your particular circumstances.