When you’re self-employed, one of your biggest expenses is self-employment taxes (Social Security and Medicare taxes). These are a flat 15.3% tax on all or a good chunk of your income.
What if there was a way to reduce these taxes dramatically, almost as if by magic? Sound too good to be true? It’s not. You can save big on self-employment taxes by using an S corporation.
What is an S Corporation?
An S corporation is a corporation or limited liability company (LLC) that has chosen the S corporation form of business taxation. You do this by filing a simple form with the IRS.
With an S corporation, all business profits “pass through” to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships, and LLCs) and pay tax on them at their individual tax rates. The S corporation itself does not pay any income tax.
Yet, an S corporation must file an information return (Form 1120S) reporting the corporation’s income, deductions, profits, losses, and tax credits for the year. Shareholders get a Schedule K-1, which lists their shares of the items on the corporation’s Form 1120S. It is the responsibility of the shareholders to file a Schedule E with their personal tax returns (Form 1040), showing their share of corporate income or losses.
You don’t have to have a large business to have an S corporation. Indeed, the majority of S corporations have only one shareholder.
Forming an S corporation lets you enjoy the limited liability of a corporate shareholder or LLC owner. But you pay income taxes as if you were a sole proprietor or a partner in a partnership.
Why most people form S Corporations: Self-employment tax savings
Most business owners choose the S corporation form of taxation for their business for one reason: it can save substantial Social Security and Medicare taxes.
When you’re a sole proprietor, LLC owner, or partner in a partnership, you’re not anyone’s employee; you’re a business owner. As such, every cent of profit your business earns is subject to self-employment taxes.
These consist of two separate taxes: the Social Security tax and the Medicare tax. You only have to pay the Social Security tax up to an annual income ceiling. But you must pay Medicare tax on all of your self-employment income.
Social Security and Medicare tax rates depend on your income.
Example: Bill earns $100,000 in profit from his consulting business. He is a sole proprietor. He must pay $15,300 in Social Security and Medicare tax on his income.
How an S corp impacts taxes
Things surprisingly change when you form an S corporation. You’re no longer a simple business owner. Instead, you wear two hats: You’re the shareholder of an S corporation, and you’ll also become your corporation’s employee.
Your corporation must pay you employee wages for your work (which the corporation deducts). You and your corporation must pay Social Security and Medicare taxes on these wages. Your corporation pays half these taxes itself as your employer, and you cover the other half through employee withholding.
Yet, your corporation doesn’t have to pay all its profits to you in the form of employee wages. Instead, it can give you some of the profits in the form of a shareholder distribution.
These profits pass through the S corporation and paid to you as a shareholder, not as an employee for your services. You do not have to pay employment tax on such corporate distributions. You only pay income tax on them at your individual tax rate.
Example: Bill from the above example forms a one-shareholder S corporation to own and operate his consulting business. He works as its sole employee and is paid $60,000 in employee salary and a $40,000 shareholder distribution. He and his corporation must each pay $4,590 in Social Security and Medicare tax on his employee wages, for a total $9,180 tax. No Social Security or Medicare tax is necessary on his $40,000 distribution. He saves $6,120 in tax compared to being a sole proprietor.
You must pay yourself a reasonable salary
The larger your shareholder distribution, the less Social Security and Medicare tax you’ll pay. If you took no salary at all, you would not owe any of these taxes. As you might expect, however, this is not allowed.
The IRS requires S corporation shareholder-employees to pay themselves reasonable employee salaries. This is at least what other businesses pay employees for similar services. If you fail to do so, the IRS can recharacterize all or part of your distribution as employee wages and require you to pay Social Security and Medicare tax on them.
Downsides to an S Corporation
S corporations aren’t perfect. If they were, everyone would be using them. They come with certain added expenses and paperwork. Some states impose special taxes on them.
Accounting and payroll costs: Accounting and payroll costs are much more than when you’re a sole proprietor or single-member LLC owner. You’ll have to prepare two tax returns instead of one, do employee payroll, and keep corporation accounting records. You should hire an accountant or payroll tax service to help you with these chores. This type of service will easily cost at least $2,000 to $3,000 per year.
Unemployment insurance: When you work as an employee for your S corporation, it must pay unemployment insurance taxes. There are both state and federal unemployment insurance taxes. Every S corporation must pay the federal unemployment insurance (FUTA) for you, its employee. This is a maximum $420 tax.
Some states require payment of state unemployment insurance taxes as well. Others don’t require this if you’re your S corporation’s only employee. State unemployment insurance costs a few hundred dollars per year. But if you pay it you get a credit against FUTA, and your FUTA payments are smaller.
Other insurance: Depending on your state, you may have to pay state disability insurance. Depending on your state, you might also have to obtain worker’s compensation insurance coverage. However, most states don’t require this for corporations with one employee/shareholder.
State taxes: Some states impose special taxes on S corporations. For instance, California levies a 1.5% tax on S corporation income, with a minimum $800 tax due each year.
