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
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
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
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