Forming An S-Corporation To Reduce Self-Employment Taxes

A potential advantage of incorporating your business into an S-Corporation is the ability to reduce the Social Security and Medicare taxes that you pay.

S-Corporation Vs. 1099 simple Example
Let’s say you have two self-employed people, Frank and Mary, who are both independent photographers. Their businesses make the same net profits of $60,000. The only difference is that Frank is a Sole Proprietorship and Mary is an S-Corporation.

Because Frank is a sole proprietorship, there is no difference between him and the business. They are one and the same. Therefore he has to pay self-employment taxes (Social Security + Medicare) of 15.3% on the entire $60,000 annual net profit, or about $9,000 in just self employment taxes. He also must pay federal income taxes on that income.

Mary is a bit different. She incorporated her one-person business into an S-Corporation, which is a separate entity. She wears two hats: she is the owner of that corporation, and also the employee.

S-Corporation are a ‘pass-through’ entity, which means all the profits of the corporation pass through directly to the shareholders’ tax returns. S-Corps do not pay corporate income taxes. However, the classification of this profit also matters:

As an employee, she just assigns herself a “reasonable salary” as required by the IRS. She does some research, and finds that similar photographers in her area earn $20 an hour. $20 an hour x 40 hours a week = $800/week, or $41,600/year.

As the corporation shareholder, she owns a business with $5,000 of overall profits each month, but also pays out $4,000 for that one extremely loyal employee. That means $1,000 per month is not paid out as salary, and will be distributed to the shareholders (her) as dividends, or unearned income.

At tax time, Mary gets $41,600 a year in earned income as an employee, and $18,400 in S-Corp distributions as a shareholder. You only pay self-employment taxes on earned income. $41,600 x 15.3% = $6,364.80 She also must pay federal and local income taxes, the same amount as Frank.

So as an S-Corporation, Mary paid $2,815.20 a year less than Sam in taxes.

Wow!
Basically, you are saving self-employment taxes on whatever profits are not counted as salary. In the past (and also in the present), aggressive business owners have tried to take all their income as dividends and receive zero salary, but the IRS has been cracking down on this.

As you can see, the benefit can be really significant as overall net profit increases. The difference between $90k salary vs. $50k salary/$40k dividends is $6,000 a year in savings. Remember, you have the right to structure your business to minimize taxes.

The main hurdle with this strategy is that the IRS gives basically no guidance as to what is a “reasonable” salary. From the case studies that I have read, the IRS does not want to be in the position to decide what people ‘should’ earn. People who have good substantiation of why they chose the salary they did have passed through audits successfully. People who didn’t and took unreasonably low salaries got their dividends recharacterized as earned income, and got charged back-taxes and penalties.

Some accountants use the “50/50 rule”, which says that your salary should be no less than 50% of the net profit, allowing the other 50% to be distributions. This is more of an anecdotal rule from what I have read, and has no basis from any IRS source or hard evidence that I am aware of.

I should also note that if you pay less in Social Security taxes, this may affect your future Social Security earnings in the future, as your salary is seen as lower. However, if you’re like me, you’d much rather take the money now as opposed to hoping to get it back 40 years from now.
 



 

1099 Contractor Vs S - Corp.

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