The Tax Advantages of Using an S-Corporation

Small business owners love to use S corporations. When we begin working with a new client earning 1099 income, we almost always recommend setting up an S corporation. There are many reasons an S corporation can make sense, the biggest one being that it is a great way to lower your self-employment tax. Let’s dive in and explore why S corporations are one of the most popular forms of doing business.

What is an S corporation?

The term S corporation refers to the tax treatment of a legal entity. It is created by filing an election with the IRS where the shareholders ask to be taxed as an S corporation. The most common setup we see is a business owner forming an LLC and then electing to have it treated as an S corporation for tax purposes. There are restrictions on who can form S corporations (e.g. less than 100 shareholders, individuals only, etc), but the IRS is pretty lenient on allowing S corporation status for those who qualify.

Self-employment tax

Income from sole-proprietors and partnerships is generally subject to a 15.3% self-employment tax (on top of the income tax), while income from S corporations are not. Sole-proprietors (reporting business income on schedule C of their personal returns) are subject to two layers of tax – self-employment tax and income tax. For example, a sole proprietor earning a net income of $50,000 would pay $7,065 in self-employment tax AND $3,097 in income tax (self-employment calculation includes a deduction for ½ of the tax). For someone making $50,000, cutting a check to the IRS for over $10,000 in taxes is excruciating – and it doesn’t have to be that way! The S corporation’s main purpose is to help avoid that second layer of taxation.

While income from an S corporation is not subject to self-employment tax, there is one big catch: the IRS requires that the owner of an S corporation who is active in the business pay him/herself a reasonable salary. That salary is subject to the same two taxes that make up the self-employment tax (social security and Medicare). Thus, the strategy of an S corp owner is to pay themself as small of a salary as possible without going too low and being deemed “unreasonable” by the IRS. The adage, “Pigs get fed. Hogs get slaughtered” applies perfectly in this situation.

What is considered reasonable?

The IRS provides a list of factors to consider when determining a reasonable salary, but a seasoned veteran CPA (such as those at Welch Olsen LLP) can also help you determine what is reasonable. We have hundreds of salary discussions every year with our clients, and a general starting point for us is the lesser of the social security maximum ($137,700 in 2020) or 1/3 of net income for the year. That is just where we begin our discussion – every situation is unique and different. Sometimes we go up from there and sometimes we come down.

Let’s look at an example.

To show how money is saved using an S corporation, let’s walk through an example. Phillip earns $100,000 as a real estate agent in his own name. He would be taxed as follows:

Federal Income Tax: $10,065
Self-employment Tax: $14,130
Total Tax: $24,195

Now let’s say instead Phillip had operated under his own S corporation during the year. He chose $25,000 as his reasonable salary. His new tax liability would be as follows:

Federal Income Tax: $11,000
Self-employment Tax: $3,532
Total Tax: $14,532

His total tax savings would be nearly $10,000! ($9,663 to be exact.) There are too many business owners that have no idea about the tax savings potential of an S corporation, or who have been told by well-meaning but ill-informed friends to steer clear of complicated S corporations. This strategy works. We use it to help save our clients hundreds of thousands of dollars every year.

Other advantages

In addition to drastically lowering your self-employment tax, an S corporation also creates additional deduction opportunities—namely retirement contribution options and self-rentals (covered in future articles).

Disadvantages

This wouldn’t be an honest article if we didn’t mention the downsides to utilizing an S corporation. The four main disadvantages are:

• Additional tax filings – you have to file a separate tax return for your S corporation.

• Reasonable compensation is required – you must determine a reasonable salary for yourself and then run payroll, complete with quarterly and annual filings, timely payments, etc. (We can help!)

• State taxes (rarely) – some states require an additional tax for S corporations (e.g. California has a minimum franchise fee of $800 for S corporations).

• The IRS won’t like you as much – you will go from one of their highest paying suckers taxpayers to a well-oiled, tax efficient machine. If this bothers you then you probably don’t want us as tax advisors.

For most business owners, stepping into the S corporation world means hiring a CPA to make sure everything is filed correctly and on time. A CPA’s job is to help you save money and keep you out of trouble – but that service comes at a price.

When does it make sense financially to set up an S corporation?

We tell our clients that it doesn’t make sense to complicate their tax situation until the benefits outweigh the costs. We have found the breakeven point (i.e., your tax savings minus what you pay us to set everything up) is just shy of $20,000 in net income. That is to say, generally speaking, if you make more than $20,000 in net income (business income minus expenses) during the year, you will save money by setting up an S corporation. If you make less, other strategies would likely make more sense for you (e.g., maximizing your business deductions).

So what now?

Give us a call or contact us if you’d like to walk through your unique tax situation and see if an S corporation would be right for you.