S-Corporations 101: Maximizing Savings and Potential Pitfalls

In this two-part series, we'll explore how S-Corporations can help you save money and why they might not always be the best choice for every business.

Part 1: How S-Corps Save Money

Before we delve into the money-saving aspects of S-Corporations, let's understand your options when it comes to business structures and taxation.

1. Sole Proprietorships:

When you initially start your business, it often operates as a sole proprietorship. This means your business has no separate legal entity, and your revenue and expenses are reported on Schedule C of your personal tax return. Profit from sole proprietorships is subject to both income and self-employment taxes, including Social Security and Medicare taxes. Self-employment tax can add up significantly, making it a costly choice for business owners.

2. LLCs and Partnerships:

Some entrepreneurs opt for Limited Liability Companies (LLCs) from the start. Single-member LLCs are initially treated like sole proprietorships for tax purposes. Multiple-member LLCs are initially taxed as partnerships, with each partner being responsible for income and self-employment taxes on their share of the profits. This structure can also lead to substantial self-employment tax expenses.

3. S-Corporations:

S-Corporations are a solution to the self-employment tax problem. To form an S-Corporation, you begin with an LLC or C-Corporation and then make an S-election by filing paperwork with the IRS (and possibly your state). S-Corporations pass their profits to owners, who report income tax on their share of the profit. However, the key advantage is that they don't pay self-employment tax on the entire profit, unlike sole proprietorships, single-member LLCs, and partnerships.

S-Corporations are required to pay employer taxes (similar to self-employment tax) only on the reasonable salary they pay to owners. Any remaining profit, after paying the salary, is subject only to income tax. This approach minimizes self-employment tax and forms the foundation of S-Corporations' money-saving strategy.

Determining Reasonable Compensation:

While S-Corporation owners must pay themselves a salary, the IRS does not provide a precise definition of "reasonable compensation." This lack of clarity often leads to disagreements among accountants. Some suggest a fixed ratio of profit to salary (e.g., 40%-60%), but this approach doesn't hold up in IRS audits.

Others, including us, recommend determining reasonable compensation based on real-world data and salaries for similar roles. This ensures a well-informed decision and reduces the risk of IRS scrutiny.

Other Considerations for Reasonable Compensation:

Local laws also play a role in determining reasonable compensation, ensuring that owners are paid at least minimum wage. Furthermore, if most of your business's revenue is generated through your personal services (e.g., consulting or freelancing) and you are the sole worker, your entire profit should be classified as reasonable compensation, following IRS guidelines.

Beware of Fraudulent Low Salaries:

Intentionally setting a low salary to minimize employer taxes is illegal and can lead to severe consequences. IRS audits can reclassify distributions as salary, triggering penalties and interest. Additionally, by underpaying self-employment tax, you reduce your contributions to Social Security, impacting your future retirement income.

An Example: Let's walk through a simple math breakdown to demonstrate how an S-Corporation (S-Corp) owner can save money on taxes compared to a sole proprietorship or single-member LLC.

Scenario:

- Business Profit: $100,000
- S-Corp Owner's Salary: $50,000
- Tax Rate for Business Income: 24%
- Self-Employment Tax Rate (Social Security and Medicare): 15.3%
- Federal Income Tax Rate (individual): 22%

Comparison: S-Corp vs. Sole Proprietorship

1. Sole Proprietorship (Self-Employed)

As a sole proprietor, you would report the entire $100,000 business profit as personal income, subject to both income tax and self-employment tax (Social Security and Medicare).

- Income Tax on $100,000: 24% ($24,000)
- Self-Employment Tax (15.3% on $100,000): $15,300

Total Tax Liability: $24,000 + $15,300 = $39,300

2. S-Corporation (S-Corp) Owner

In this scenario, you form an S-Corporation and pay yourself a reasonable salary of $50,000. The remaining $50,000 of profit is distributed to you as business income.

- Salary: $50,000
- Income Tax on Salary (22%): $11,000
- Self-Employment Tax on Salary (Social Security and Medicare, 15.3%): $7,650

- Business Income: $50,000
- Income Tax on Business Income (24%): $12,000

Total Tax Liability: $11,000 (Salary Income Tax) + $7,650 (Salary Self-Employment Tax) + $12,000 (Business Income Tax) = $30,650

Savings with S-Corp: $39,300 (Sole Proprietorship Tax) - $30,650 (S-Corp Tax) = $8,650

In this simplified example, forming an S-Corporation and paying yourself a reasonable salary allows you to save $8,650 in taxes compared to operating as a sole proprietor. This savings is primarily due to avoiding self-employment tax on the portion of the business income not taken as salary, while still paying income tax at individual rates. Keep in mind that the actual savings can vary depending on many factors, and it's important to consult with a tax professional to determine the most appropriate strategy for your specific situation.

Part II: Why S-Corps Aren't Always the Best Choice

While S-Corporations may seem like a tax-saving paradise, there are several other factors to consider:

1. Costs of Running an S-Corp:

S-Corps must run payroll to pay owners, which can be an additional administrative expense. This includes payroll software costs, federal and state unemployment insurance, and the expense of filing a separate business tax return. These costs can total at least $700 per year.

2. Qualified Business Income Deduction (QBI):

The QBI deduction, introduced under tax reform, allows many businesses to deduct 20% of their profit. However, S-Corporations reduce their profit through owner salaries, impacting the net tax benefit of an S-Corp.

3. Local Tax Issues:

In some states and cities, S-Corps are subject to income, excise, and franchise taxes, offsetting the potential self-employment tax savings.

Conclusion:

S-Corporations are not a one-size-fits-all solution. While they can save money by minimizing self-employment tax, they come with additional costs and considerations. Before choosing this business structure, carefully evaluate your financial situation, including the net savings and potential pitfalls.

Remember, it's essential to make informed decisions about your business structure and not solely rely on advice from the internet. Consult with a qualified professional to determine the best path for your specific circumstances.