Classification Clarification

Choosing a business’s legal structure—the way a business is classified with the Internal Revenue Service (IRS)—is one of the most important decisions shop owners have to make. There are several options available, and choosing which is best isn’t a decision to be taken lightly.

Chea Romine, managing partner of accounting and consulting firm Romine CPAs & Associates, says most auto repair businesses are classified as sole proprietorships, single member limited liability corporations (LLCs), multiple member LLCs (MMLLCs) or S-Corporations (S-Corps). But only three of those options are feasible for professional repair shops because sole proprietorships offer no personal liability protection, Romine says.

“If something goes wrong, it can be catastrophic,” Romine says. “LLC and S-Corp are really the only two viable options for shop classifications. That’s where most small businesses should be headed.”

But how do you choose between an LLC and an S-Corp?

The answer, Romine says, comes down to two main issues—tax rates and business complexity. Assessing your desired ease of oversight, complexity of business structure and tax breaks can make your decision a bit easier.

Though shops should seek advice from their own financial consultant before making a decision on business classification, Romine breaks down the key differences you need to know.

Consider Your Taxes

From a management perspective, operating an LLC is much easier compared to an S-Corp with significantly fewer administrative requirements. But Romine says the complexity of the business structure shouldn’t be the only criteria to consider. Although classifying as an S-Corp comes with higher levels of necessary oversight and business infrastructure, there can be financial incentives in that type of entity during tax time.

“Shop operators should be proactive about analyzing their business classification because they could be missing out on thousands of tax dollars every year,” Romine says. “The LLC designation isn’t always the most tax advantageous for profitable companies, and you could enjoy more favorable tax reductions with an S-Corp depending on your level of profitability.”

That’s because the S-Corp classification eliminates a portion of self-employment taxes that LLC owners pay. Since owners of LLCs cannot be listed on payroll, owners pay income tax and 15.3 percent self-employment tax on all of the company’s profit.

Making A Change

Remember that your initial choice of business classification isn’t permanent. If you’re already an LLC, for instance, you can reclassify as an S-Corp any time if the possibility of tax reductions makes sense to you.

Romine says the conversion process from an LLC to an S-Corp is free and easy. You just have to file one form with the IRS by March 15 of the current tax year to reclassify. Owners must make all of the appropriate changes to the business structure after filing the paperwork.

“It’s not a long, difficult process,” Romine says. “It’s that simple.”

For example, say you have a $1 million shop with 10 percent net profit of $100,000 that’s classified as an LLC. The owner pays income and self-employment tax on that total amount, resulting in $15,300 for self-employment taxes plus income taxes.

Owners of S-Corps, on the other hand, add themselves to payroll like all other employees and collect a specified salary. Owners pay income tax and self-employment tax on their salary, while the business only pays income tax on the remaining profit—eliminating self-employment taxes on a portion of the business profit.

For example, if that same shop with $100,000 of profit were classified as an S-Corp, the owner could claim a $40,000 salary, which would incur income and self-employment taxes. The remaining $60,000 of profit would only incur income tax. That eliminates paying 15.3 percent of self-employment tax on $60,000, which amounts to more than $9,000 in tax savings.

Romine says S-Corps do create additional annual business costs, however, so you’ve got to assess your shop’s profitability before considering a move to that business classification. There are initial costs of setup, as well as annual legal and accounting costs, and it’s important to identify whether your tax reductions outweigh that overhead.

As a rule of thumb, Romine says the S-Corp designation adds roughly $1,000 of business costs a year. Your shop should generate a minimum of $30,000–$50,000 of profit in order to save enough tax money to justify making the changing the classification.